Monday, June 01, 2009

Treasury Market: Gonk!

John Maynard Keynes once famously said "The market can remain irrational longer than you can remain solvent."

Now, I believe in a generally efficient market, but not the one you read about in college. The textbook theory of efficient markets describes a world were security prices constantly move toward "real" value. Where information is instantly disseminated, asset, and priced into security valuation.

In real life, the "correct" assessment of information isn't so black and white. Especially since in real life, economic data is often pointing in multiple directions at the same time. Market participants must then weight various bits of data to make a valuation determination. Some will put more weight on certain pieces of data, while others will overweight other items.

This is starkly evident in the U.S. Treasury market right now. I've argued that inflation is of little concern here, despite some improvement in the economy. I point to data like today's release of Personal Income and Spending. It shows that consumers have more income to spend for the first time in 7 months. But they aren't actually spending that income: Expenditures declined by 0.1%. I've said it before and I'll say it again, there is no consumer inflation without consumers spending more money in nominal terms. Deflation is the bigger worry when consumer spending is declining.

Others take the other side, arguing that massive government deficits and the ever-running Fed printing presses will cause inflation. The dollar and foreign willingness to own U.S. Treasuries also plays into the bearish Treasury view.

The difference of opinion is especially wide now. The inflation camp suggests 10-year Treasurys rise to 6-7% or even higher. The deflation crowd currently sees a 10-year Treasury yield which is currently above typical real yield. The median real 10-year yield (just taking 10yrs minus CPI) is about 2.9% since 1989. If I assume inflation will print at or near zero in the coming months, then Treasuries seem like a deal at 3.70%. Obviously if you foresee inflation accelerating to anything above average, even something as benign as 4%, Treasury yields are far too low.

No near-term event is really going to resolve the debate either way. The economy has improved substantially since last fall, when I was writing most about deflation. Despite this, I still see a consumer preoccupied with balance sheet repair than buying new dishwashers. The inflation crowd is the same way. When the dollar was stronger earlier in the year, I didn't see the inflation crowd backing off, and why should they? Their basic thesis was still in tact.

The perception of the debate is colored day by day based on where the market is going. Friday the Treasury market was up substantially and I got a few e-mails congratulating me on my recent buy. I responded (and I blogged) that I thought it was just a month-end extension, not a validation of my view. Lo and behold, the rates market gets crushed today.

In fact, I argue that an argument always sounds smarter when its backed up by recent market moves. I can't tell you how often investment managers and traders come on CNBC and make an "argument" for a certain position that doesn't contain any argument at all. For example, if one went on CNBC and said "I think the long bond is going to 8% because inflation will spike, the Asians will dump Treasuries, and the deficit will get out of control." That's not really an argument is it? Its just a statement of cause and effect. We know Treasuries will get crushed if those things happen. The question is why might those things happen. Right? That argument is like a detective pronouncing a case closed after determining that the victim was shot. Who shot the victim is the real question.

Anyway, if you make the Treasury bear case on a day when Treasuries are getting crushed, the human mind instinctively find your argument more compelling. This guy says the Treasury market is going to get crushed, and look at it! Its already happening! If you watch, you'll notice that on any given day, CNBC tends to have more interviews with people who agree with that day's market action than not. Can't be a coincidence. It makes the casual observer feel like CNBC has on smart people!

What makes this all tough for the serious analyst is that you have to balance holding firm to your viewpoint while admitting you could be wrong. Its another way of saying that the toughest thing in investing is a sell discipline. I'm long Treasuries now (only avoided a real shellacking based on some good technical analysis). I believe in my deflation thesis, but I know I could be wrong. The inflation camp isn't stupid. There is a valid argument for much higher interest rates. The smart trader puts his ego aside and admits when he's wrong.

Many have e-mailed me asking for signposts that I'm wrong. I know what my signposts are, but I'd rather put it back on the readers. E-mail me (accruedint AT with the best arguments you have (could be your own, another blogger, a research report, etc.) for a significant Treasury sell-off. I read a lot of arguments myself, of course, but I won't pretend that I read everything. Send me the best stuff you have. Over the course of this week, I'll respond point by point to some of the best pieces I get. While I'm making my points, I'll also try to show the indicators I'm watching that would tell me that I'm wrong and the opposing writer is right. We'll call it Deflation vs. Inflation week! Its a smackdown!


BT said...

I'll admit that not too long ago I thought this was the end of the American economy, and I think a lot of that was due to the bias you discuss in your post. I've been trying to stand back and look at what is going on, big picture, and I do not see a clear direction. I can make a case for both sides, but I think I am more worried about inflation expectations than deflation.

I think everyone is trying to make this into the Great Depression, and for a while it definitely looked like it. But do you think the experience since fall 2008 is honestly seared onto the psyche of of the American consumer? Sure, a record number of people have lost their jobs and there will be / is substantial cut back in credit. But, just to play devil's advocate here, how many months of saving do Americans have in them? We are talking about a population that has for decades bought everything under the sun. And we are asking them to go cold turkey? At some point, we decide to have an economy. People gradually start to take risks. This applies to the decision to buy something new the same as it applies to moving from one asset class to another.

The question is going to be about whether the Federal Reserve is sufficiently independent to pull on the reins when everyone is saying that it needs to continue to let go. I think the next FOMC meeting is going to say a lot about whether that is going to happen. The Fed cannot fight supply right now, and if it tries everyone in the world is going to think Bernanke is out of touch.

viking said...

Unprecedented T supply meets greatly diminished demand. Ergo Turbo in Beijing and Barry soon to Mecca.

In Beijing, Univ. of Peking students laughed when Geithner said Ts were safe.

Chinese moving toward short end of the curve. Which they should.

Treasuries are going down.

Anonymous said...

had to laugh at "Where information is instantly decimated, asset, and priced into security valuation."
in b-school i learned that information typically gets disseminated; but in the current world, i think you are correct in the tongue-in-cheek (possibly unintended) comment that info is decimated.

Stephen Chang said...

I'll first admit that I am more agnostic about the bond market direction at the moment.

but the most compelling bear case I find is the argument that over the longer term, the bond market (i.e. 10yr yields) act as an automatic stabilizer for the economy, which then leads to a mean-reversion nature for the 10yr yield.

if we exclude the post-lehman extreme flight to quality move, 10yr yields ranges 3-6% in the last 10yrs (where 3-6% is also considered to be the typical range of normalized Fed funds). So despite recent moves, we are still in the bottom end of the range and can easily moves toward 5%. Granted I agree with your views on the inflation picture now is more akin to mid 2003, but that still makes bonds somewhat expensive at current levels.

Alex Morrow said...

An additional anchor on consumer spending is the reduction in available credit. The card companies are reining it in.
I agree with your argument on inflation and I think what we are seeing at the moment is a reversal of the flight to quality.
This skewed bond prices and we're now in a normal adjustment as money returns to other asset classes.

Accrued Interest said...


Heh... Freudian slip? I fixed it.

JoshK said...

Great post. I don't think the strongest advocate of either position is without serious doubts that he or she may be 180 degrees wrong.

I know this isn't provable in any way, but in my guy, I feel that our country has been moving for a long time in the direction of countries like Argentina and Venezuela. There is a popular desire for all things free and protected by the government. And the debts are unpayable. There's no way we are going to reduce access to Avastin and there's no way we can pay for it.

Now as far as a sign that I'm right or wrong, I'm still working on that one.

EJC said...

Great post.

I disgree with your statement about lack of inflation in absence of consumer spending. Given US consumption of foreign made goods, I think it's possible for US inflation to exist even in the absence of strong US consumer spending if the USD weakens further.