Monday, October 26, 2009

Bonds and the U.S. Dollar: Use the commlink? Oh. I forgot. I turned it off.

Call me a sucker for the classics. Be it the original trilogy, the old Kenner figures, the "Nyub Nyub" song at the end of Jedi, or the classic theories of exchange rates. While the old classics, like interest rate parity or purchasing power parity, may not exactly fit reality (especially not in real time), I think the concepts remain useful. That is to say that as inflation rises, a nation's currency should depreciate. As interest rates fall, suggesting that there are few good local investment opportunities, the currency should similarly depreciate.

I wrote several weeks ago that the dollar should depreciate for exactly those reasons (I even made the same classics joke). The U.S. should have higher relative inflation vs. other countries, and the Fed would likely hold U.S. short-term rates lower than other countries.

A corollary to the above discussion would suggest that bond yields should normally be inverse correlated to the dollar. If the dollar is falling because inflation is rising, that should also be reflected in higher bond yields.

Or if you want to make a deficit-based argument for a weaker dollar, to which I don't ascribe, but either way, it would still suggest that weaker dollar = higher bond yields. If the deficit is causing a flight from U.S. assets, then Treasury prices should fall as money flows out of the U.S.

Indeed, that is exactly the pattern you saw for the first half of this year.

Lower dollar coincided with higher bond yields. Exactly what we'd expect.

But then a funny thing happened on the way back to normal. Like Zam Wessel, The dollar/bond relationship went completely the other way.

What's going on here? The dollar gets weaker, bond yields fall?

It traces back to why the dollar is falling. Unfortunately we're going to have to get away from the classics and consider what's going on right now. Right now, the U.S. is the cheapest place to borrow money anywhere in the world. If you are a non-dollar entity, whether you are a government, central bank, insurance company, etc., your cheapest source of funds is anything U.S. LIBOR-based. You can borrow in dollars and re-invest in something local to you. That's dollars flowing out of the U.S., thus pushing the dollar weaker.

Meanwhile if you are a U.S.-based investor, your cheapest source of funding is still something U.S. LIBOR-based. Remember that banks are still sitting on huge deposit bases and are either unwilling to lend or unable to find worthy borrowers who want credit. What do they do with their deposit base? Invest it in bonds! If your borrowing cost from the Fed is 0.12% (approximately where Fed Funds is trading), you can buy 2-year notes at 1% and make tremendous carry. Just take a gander at the recent bank earnings. The NIM's are huge.

When is the Fed going to take away the bowl of Aunt Beru's famous blue milky looking punch? According to a recent story from the Financial Times, maybe sooner than we think. I had long thought that a Fed hike was a long way away but as consumer spending starts rising, the risk of inflation returns. Now it seems like some number other than zero is probably the appropriate funds rate.

Plus it would be nice to think that the Fed realizes how zero Fed Funds is impacting financial markets and the potential, potential mind you, for it to create dangerous distortions. Whether they actually do realize this or not is any one's guess.


Anonymous said...

.........What's going on here? The dollar gets weaker, bond yields fall?.......
In the Eco parlance,it is a"trilemma". There are 3 variables - exchange rate, interest rate and independent economic policies. Govt (fed + treasury combined) can manage only two of these three. Global economic marketplace determines the third one.

In this particular, you are referring to, dollar is weaker. But yield is not going up, because lower dollar is NOT able to create sufficient inflation for the bond yield to raise.

Advant Guard said...

You are nuts.
With a trillion in excess reserves, the Fed Funds rate has as much to do with controlling the amount of lending as Paris Hilton's IQ.

Normally, banks have excess capital and are short of reserves. The Fed Funds rates controls the cost of funds for lending. Currently, banks have excess reserves and are short of capital (even bank that currently have the required capital are listening to talk about raising capital ratio and deciding to be extra careful with their lending.)

If you kept track of recent earnings announcement, you would have noted the number of banks reporting losses -- that's right those banks have less capital than they did three months ago.

The Fed can't even keep the Fed Funds rate at 25 basis points (despite that being what it pays banks for their excess reserves.) Raising the Fed Funds rate would be an exercise in futility until banks have more capital and the Fed can mop up the excess reserves.

Salmo Trutta said...

Banks don't loan out excess reserves. When CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially, the creation of an equal volume of new money, somewhere in the banking system.

Today, the member banks are unencumbered in their lending operations. Excess reserves are now bank earning assets (which compete in the marketplace with all other investments).

However if the Treasury needed support operations from the FED, then the remuneration could be raised (as an offset to gov't purchases).

The desk can only control interest rates in the short-run (because the money supply can never be managed by any attempt to control the cost of credit).

EconomicDisconnect said...

Ben Bernanke is "as clumsy as he is stupid". No way the FED rate moves before 2011, and events of this fall and early next year will seal the deal. The problem with ZIRP is that "once you start down the dark path, forever will it dominate your destiny!".

steveplace said...

holy crap my wife was pissed when they took out the nyub nyub song

Salmo Trutta said...

Positive interest rate differentials give the dollar exchange rate support. And an "overvalued" dollar is one of the principal contributors to our burgeoning trade deficits.

Any significant repatriation of dollars, by reducing the supply of loan-funds, will force interest rates up, thus increasing the federal deficit and the burden of all new debt. This could trigger a downswing in the economy resulting in more unemployment, more unemployment compensation, less tax revenues and larger federal deficits.

Both high interest rates, and high taxes, induce stagflation and erode the tax base. There is a limit to the volume of debt that can be financed from taxes.

To appraise the effect of the federal budget deficit on interest rates, it is necessary to compare the deficit, not to the debt to GDP ratio (a contrived figure), but to the volume of current savings made available to the credit markets. The 2008 deficit ($451 billion interest expense) is absorbing about 18 percent of gross private savings.

It is obvious that the inflationary spiral in domestic prices will be relentless, and the price of long-term securities will continue to fall under these pressures.

I.e., the fall in the exchange value of the U.S. dollar is the direct result of a $7.4 trillion dollar trade imbalance (ever since the U.S. became a net debtor country in 1985), and it is compounding.

TR said...

You are assuming that deflation is an artifact of history. It's not, and dollar strength, lower USG bond yields, and equities to the dumpster will serve as proof. Give it a little time.

The Oriole Way said...

The interesting thing to me is the cluster of data points that cause the inverse correlation, all of which are from September and October 2009. If you run a regression on just those two months, the traditional relationship holds (albeit weakly). I think that what we are mostly seeing is yields in the same range but a much weaker dollar. The yield levels aren't affecting the dollar.

Taylor said...

Off topic here, but last time inflation ran away in the late 70s, what were CD rates like then? Were the banks only selling them short term (3 months)? Thanks.

Salmo Trutta said...

Bloomberg: "Confidence among U.S. consumers UNEXPECTEDLY fell in October to 47.7 from a revised 53.4in September"

The proxy for real-growth topped at .50 in Jul and bottoms at .01 in Nov. Nov. should be the time to enter shorts.

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