A Bubble in the Bond Market?

Jeremy Siegel and Jeremy Schwartz claim there is a U.S. bond bubble:

Ten years ago we experienced the biggest bubble in U.S. stock market history.... A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites.... We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.... 

While they may be right that bond prices have gone up because of economic pessimism and the associated low interest rates, there is good reason for the pessimism.  It's called a recession, not just any recession but a balance sheet recession. The balance sheets of households in particular have deteriorated so much they are back to where they were about 20 years ago.  It will probably take years to heal household balance sheets.  If so, there is little reason  to believe there is going to be a robust economic recovery anytime soon that will push up interest rates and cause bond prices to crash.  The importance of weak household balance sheets cannot be overstated.  It is the main reason why the federal government balance sheet is currently growing (i.e. the contraction of household balance sheets is being offset by the expansion of the government balance sheet) and therefore is, in part, indirectly responsible for all the concerns about exploding fiscal deficits.  Siegel and Schwartz try to dismiss this concern by saying the problem is overstated but I don't buy it.  Neither do  the economists in the Survey of Professional Forecasters. They see a weak recovery at best at least through 2011.  Even if one accepts Siegel and Schwartz's view that there is excessive pessimism in the market it is still hard to talk about bubbles in the bond market like on does with the stock market as noted by Brad DeLong.   

In short, there is economic weakness a far as the eye can see and this suggests interest rates will probably be low for an extended period of time.  Therefore, even if we do have a bond bubble it is not going away anytime soon.  As Colin Barr says, for now we may be stuck with an unpoppable bond bubble.

Update: Felix Salmon and Karl Smith make similar points.
Update II: Barry Ritholtz doesn't quite call it a bubble, but says it has the markings of something close to a bubble.

Further Insights on the New Interest Rate Conundrum

Does the new interest rate conundrum have you perplexed? Then try this article by Edward Hugh that delves into the debate between Niall Ferguson and Paul Krugman or take a look at this post by Josh Hendrickson where he argues we should be pleased to see the rising bond yields.

Ritholtz Nicely Summarizes the Fed's New Conundrum

There has been a lot of debate as to how to interpret the rise in long-term interest rates, some of which I have noted here on this blog. Barry Ritholtz provides a nice summary:

The Bond sell off, which has been sending rates appreciably higher, is being caused by two distinctly different camps. The first are those who believe that the recession has crested and is coming to an end, that global growth will soon resume, and the Fed will therefore be raising rates.This is the Green Shoot crowd.

The other camp sneers at the Green shooters, but does not disagree with their conclusion that the Fed will soon be tightening. This is the inflation camp, and includes the gold bugs, commodity bulls, dollar bears, and hyper-inflationistas.

With Oil up 100% for the year, and the Dollar down nearly 10% from its recent peak, I find this group harder to disagree with. The irony is that each sees the Fed tightening and rates going higher. This is the conundrum the Fed finds itself in . . .[emphasis added]

Note, that even the Fed is reportedly perplexed by this development. For a longer discussion of this debate see Daniel Gross.

Martin Wolf Weighs in On Rising Bond Rates

Martin Wolf has this to say about the rise in long-term interest rates that has the Fed puzzled and others worried:

The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.

At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October. Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real.

What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone. Hurrah!

Wolf also responds to the debate among Niall Ferguson, Paul Krugman, and John Taylor.

Why Did the Yield Curve Invert Before This Recession?

Over at Free Exchange the inversion of the Treasury yield curve prior to this current recession is being interpreted as the result of a decline in the term premium, not a change in the expectation of future short-term interest rates. Specifically, the term premium allegedly declined for the following reasons:

Implicit inflation targeting appeared to be working; high and unpredictable inflation was relegated to emerging markets. That decreased the premium on long-dated government bonds. The savings glut also lowered long-term yields by increasing the demand for long-term governments, lowering their yields.

There are studies supporting this interpretation, but I am not convinced it is the entire story. For starters, if a belief in price stability led to a decline in the term premium, why did it suddenly kick in a few years ago? The Fed has had inflation-fighting credibility for several decades now so what makes the mid-2000s so special? Another problem with this interpretation is that the inverting of the yield curve was a global phenomenon. The above interpretation cannot explain why it was global. The saving glut was a regional one and its destination was regional too. At best, then, it could only have affected regional interest rates.

A more straightforward interpretation is that bond markets across the globe were sizing up the economic imbalances and foresaw the current global recession. As a result, they expected monetary authorities to cut future short-term rates across the globe and priced it into long-term interest rates. Now this is purely conjecture on my part, but I know of at least one study that provides evidence consistent with this view for the United States. Joshua Rosenberg and Samuel Maurer in a New York Fed study decompose the yield curve spread into its (1) interest rate expectations and (2) term premium components. What they find can be seen in the following figure where the gray columns denote recessions: (click on figure to enlarge.)


This figure reveals that for the United States the inverted yield curve prior to this recession was mostly the result of changes in the interest rate expectations component rather than the term premium component.

The Battle of the Spreads

The treasury yield curve spread--the interest rate on a long-term treasury minus the interest rate on a short term treasury--has been a good indicator of future economic activity. Typically, if the spread turned negative a recession was looming and vice versa. The corporate bond yield spread--the interest rate on a risky corporate bond minus the interest rate on a safer corporate bond--has also been a good indicator of future economic activity. Here, if the spread significantly increased in value then a recession was looming and vice versa. So what do these spreads now show? Are there any signs of hope? First take a look at the 10-year treasury yield minus the 3-month treasury yield spread in the figure below. (click on figure to enlarge.)

As you can see from the figure, the spread is currently relatively large and positive, usually a sign of economic growth ahead. This fact was noted by the Cleveland Fed recently as indicating the recession may soon be over. However, Paul Krugman took issue with this interpretation:

The reason for the historical relationship between the slope of the yield curve and the economy’s performance is that the long-term rate is, in effect, a prediction of future short-term rates. If investors expect the economy to contract, they also expect the Fed to cut rates, which tends to make the yield curve negatively sloped. If they expect the economy to expand, they expect the Fed to raise rates, making the yield curve positively sloped.

But here’s the thing: the Fed can’t cut rates from here, because they’re already zero. It can, however, raise rates. So the long-term rate has to be above the short-term rate, because under current conditions it’s like an option price: short rates might move up, but they can’t go down.

[...]

So sad to say, the yield curve doesn’t offer any comfort. It’s only telling us what we already know: that conventional monetary policy has literally hit bottom.

So Krguman does not take solace in the current yield curve spread. Does his interpretation find support in corporate bond yield spread? Or does it provide some sign of hope? The figure below provides an answer. It plots the corporate BAA yield minus the corporate AAA yield spread. (Click on figure to enlarge.)

This figure suggests Krugman's view is correct: the corporate yield spread is the largest it has been since the Great Depression. No sign of soon recovery here.

Update: Paul Krugman replies to Dean Baker's assertion that corporate yields do not show a credit crunch.

Decomposing the Yield Curve Spread

Just last week I had a post titled "The Interest Rate Conundrum that Wasn't" where I discussed how many observers misread the flattening and then the inverting of the yield curve over the 2005-2007 period. As I noted then, the popular story was that the term premium was falling and thus there was nothing to fear from the changes in the yield curve. As we all now know, this interpretation was incorrect: the yield curve was telling us that a recession was in the making after all. Well today, Zubin Jelveh directs us to a similar posting he made back in January titled "That Trusty Yield Curve". The entire post is worth reading, but one part in particular I want to mention here. Zubin notes a study by Joshua Rosenberg and Samuel Maurer that decomposes the yield curve spread into its (1) interest rate expectations and (2) term premium components. What they find can be seen in the following figure where the gray columns denote recessions: (click on figure to enlarge.)

This figure shows--and the authors demonstrate more formally with some statistical tests--that it is changes in the interest rate expectations component that predicts recessions, not changes in the term premium. The variation in the term premium is typically too small to matter, including during the "conundrum" period. This is interesting work.

The Interest Rate Conundrum That Wasn't

Thanks to the prompting of ECB, I was reminded of the interest rate "conundrum" of 2005-2006. The "conundrum" at this time was that long-term interest rates refused to follow short-term interest rates up as the Fed tightened monetary policy. Based on the expectations theory of interest rates--which says long-term interest rates are the average of expected future short term interest rates plus a risk premium--there were two obvious interpretations for this development: (1) the risk premium had fallen or (2) the economy was headed for a recession. Despite the inordinate run up in leverage and house prices at the time--signs that U.S. economic expansion was not sustainable--many observers chose to believe some variant of (1). For example, one very prominent Fed official said the following in 2006:

Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.

Other reasons given around this time for not viewing the inverting of the yield curve as pointing to a recessions were that (1) other financial indicators such as the rise in stock prices indicated solid economic growth ahead and (2) the conundrum was a global phenomenon, not just a U.S. one. We now know the inverting of the yield curve was not a "conundrum", but simply a sign of the recession to come. The term premium and other financial indicators pointing up interpretations were off the mark in this case, while the global scope of inverting yield curves meant a global recession was in store.

The figure below--which shows the 10 year-3 year treasury yield curve spread, the NBER-dated recessions, and the recession that presumably started in 2007:Q4--indicates that during the time of the "conundrum" the yield curve spread was simply doing what it does best: predicting a recession. (Click on figure to Enlarge.)


Although many observers somehow missed this straightforward interpretation of the inverting yield curve, others got it right. For example, Calculated Risk wrote in 2005 the following:

I think the PRIMARY reason for Greenspan's conundrum is that the economy is weaker than it appears. Using GDP growth and unemployment, the US economy is healthy. But the level of debt (both consumer and government), the real estate "boom" that seems based on leverage and loose credit (see Volcker's recent comments), and the poor employment situation (especially the low level of participation) indicate an unhealthy economy. I believe this recovery is being built on a marshland of debt and the bond market is reflecting this weakness.

For some observers, then, there was no "conundrum". The inverting yield curve was simply a sign of future economic weakness. How prescient they now look.

Predicting Recessions

Here is an interesting article given my own research interest.

Financial Market Perceptions of Recession Risk
Thomas B. King, Andrew T. Levin, and Roberto Perli

Abstract: Over the Great Moderation period in the United States, we find that corporate credit spreads embed crucial information about the one-year-ahead probability of recession, as evidenced by both in- and out-of-sample fit. Furthermore, the incidence of "false positive" predictions of recession is dramatically reduced by utilizing a bivariate model that includes a measure of credit spreads along with the slope of the yield curve; indeed, these bivariate models provide much better forecasting performance than any combination of univariate models. We also find that optimal (Bayesian) model combination strongly dominates simple averaging of model forecasts in predicting recessions.

Another Look at the Policy Rate Gap

So we now know that Big Ben is not upbeat about the economy. He testified before the Senate today that the ``outlook for the economy has worsened in recent months, and the downside risks to growth have increased.'' His grim assessment gave me a good excuse to spend some time today looking at a metric I call the policy rate gap. As I have discussed before on this blog, this metric is is an easy-to-use measure of the stance of monetary policy that in conjunction with the yield curve spread does a decent job predicting NBER recessions. It is calculated by subtracting the average fedreal funds rate from the growth rate of nominal GDP for each quarter. This metric is based on the Wicksellian-like idea that if the cost of borrowing is too low relative to the growth rate of the American economy, then excessive leverage and investment is encouraged and vice versa. Using this metric, a neutral monetary policy would be one where the federal funds rate never wondered too far from the nominal GDP growth rate.

The figure below shows the policy rate gap calculated up through 2007:Q4 using two different approaches. The first approach, indicated by the red line, takes difference between the year-on-year growth rate of nominal GDP and the average federal funds. The second approach, marked by the blue line, uses the annualized quater-on-quarter growth rate of nominal GDP. Both approaches show that policy rate gap turns sharply negative during NBER recessions. The figure also shows a neutral-to-slightly easing monetary policy stance by end of last year. This figure suggests that if the U.S. is in a recession this quarter and if the past is any guide to proper monetary policy, then it is appropriate for further policy rate cuts. (Click here for larger picture)

Plugging this metric along with the yield curve spread (10year-3month) into a probit model, where the dependent variable is a NBER-recession dummy variable, creates a simple but powerful tool for predicting recessions. The model specifically was designed to predict one quarter ahead. The figure below shows the results from this model up through 2008:Q1. The red and blue lines again come from what policy rate gap was used. (click here for larger picture)

This figure shows the probability of a recession this quarter is at most about 40%, down from a high of abour 60% a few quarters back. These numbers are surprising given the considerably higher probability numbers on the recession contract at Intrade.com (65% today). What I conclude from this brief analysis is (1) either my model is misspecified (a very good chance!) or (2) Big Ben should not be as worried as he is about the economy. Time to recheck the model!

Update
I reestimated the above model, but this time included the spread between Moody's Aaa and Baa bond yield. Now, the model's recession probability for 2008:Q1 is about 60%, much closer to the 65% Intrade value. Including all three explanatory variables--the poilcy rate gap, the yield curve spread, and the corporate spread--improves the fit of the model (pseudo R2 of 63%) and produces a probability more in line with conventional wisdom. (Click here for larger picture)

The Business Cycle and Religiosity

Does economic distress increase religiosity and vice versa? This is a question that first intrigued me back in 2001, during the last U.S. recession. I was visiting my sister in Atlanta, Georgia and attended her church. During a part of the church service a microphone was passed around to individuals who then shared with the rest of the congregation what was going on in their life. Almost everyone who participated during this open mike time had just lost their job and were asking God to find a new one for them. As the right side of my brain sympathized with these suffering individuals, the left side of the brain got excited and started thinking about the econometric possibilities. I wondered, might this experience be reflecting a much broader, systematic relationship between church attendance and the business cycle? If so, were would I get data to test for such a relationship? And would this relationship be different for different denominations? I was curious and wanted to find out more.

I was a graduate student back in 2001 and had other pressings issues that put this interesting question on hold. I recently started looking at this issue again and now have a working paper titled "Praying for a Recession: The Business Cycle and Church Growth." I will be presenting this paper at the annual meetings for the Association for the Study of Religions, Economics, and Culture (ASREC) in November. My abstract reads as follows:

Abstract: Some observers believe the business cycle influences religiosity. This possibility is empirically explored in this paper by examining the relationship between macroeconomic conditions and Protestant religiosity in the United States. The findings of this paper suggest there is a strong countercyclical component to religiosity for evangelical Protestants while for mainline Protestants there is both a weak countercyclical component and a strong procyclical component.

This paper is preliminary and I would appreciate any comments on it.

This Yield Curve Paper Sounds Familiar...

Charles Goodhart and Luca Benati have a new paper on the yield curve where they "have investigated why the yield curve has appeared to have had such predictive power for future output growth at times in the past, but also why this may now have largely disappeared. [They] examine the relationship... for the US and the UK since the Gold Standard era, and for the Eurozone, Canada and Australia in the Post-WWII period... [their] results suggest that, historically, the additional predictive power of the spread for future output growth –over and above that already encoded in other macroeconomic variables – often appeared during periods of uncertainty about the underlying monetary regime."

So the yield curve's predictive power is contingent on the uncertainty of the underlying monetary regime. This finding is consistent with what Michael Bordo and Joseph Haubrich found in their paper, The Yield Curve, Recessions and the Credibility of the Monetary Regime: Long Run Evidence 1875-1997 (with Joseph G Haubrich) NBER Working Paper No10431, 2004. Here is the abstract:

"This paper brings historical evidence to bear on the stylized fact that the yield curve predicts future growth. The spread between corporate bonds and commercial paper reliably predicts future growth over the period 1875-1997. This predictability varies over time, however, particularly across different monetary regimes. In accord with our proposed theory, regimes with low credibility (high persistence of inflation) tend to have better predictability."

Monetary Stance Metric + Yield Curve Spread = Powerful Tool

In an earlier posting I showed that the nominal GDP growth rate minus the federal funds rate, called the policy rate gap, is an easy-to-use measure of the stance of monetary policy and does a decent job predicting NBER recessions. A question that kept bugging me after doing that posting is what would happen if both the policy rate gap and the yield curve spread (10yr-3m Treasuries) were used in the probit model? Well, instead of working on a paper that needs to be completed for an upcoming conference, I tinkered around with the data this morning and got some exciting results on this question. First, take a look at a probit model estimated with four lags for the period 1956:Q1 through 2007:Q2:


Again, a rough and dirty cut in need of further refinement, but I got a pseudo R-squared of 74.5%! That is a huge improvement over what I had before and a better fit than probit models that use the yield curve spread alone. Obviously, my interest was peaked so I went ahead and plugged the numbers into a cumulative standard normal distribution and came up with the following graph:

Wow! This graph shows a 100% probability for every NBER recession that happened and does a much better job with the two periods that plagued the policy rate gap results, 1984 and 1994. The only miss is 1966-1967 which is a common miss for yield curve spread models. Edward Leamer, in his KC Fed symposium paper, notes that the year 1967 should have seen a recession--like today, there was a major housing bust dragging down the economy at the time--had it not been for the increased government spending on the Vietnam War. Of interest to us now, though, the model shows there to be an almost 50% chance of a recession.

Look forward to a paper from me that further develops this approach. These results are too promising not to do a paper.

The Yield Curve and the Flight to Safety

A new paper by Glenn Rudebusch and John Williams shows that the yield curve spread is a better predictor of recessions than are professional forecasters. This fact may explain why yield curve is not used as much one would expect by the professional forecastors--they are loathe to promote a simple metric that renders them obsolete.

Given this papers timing, it is interesting to consider what impact the flight to safety in treasury bills (and out of asset-backed commerical paper) over the past few weeks has had on the current yield curve. This first figure (from the FT) highlights this drop using the 3-month treasury bill yield. Here the drop appears to be part of a downward trend even as the federal funds rate, the anchor of the short term interest rates, is stable. Note how the federal funds rate and the 3-month treasury yield track each other closley up through the middle of 2007. Thereafter, the series break, presumably because of the flight to safety (see the oppossite response in the asset-backed commerical paper). So what does this all mean for the yield curve? Does this flight to safety add noise to the yield curve's predictive ability?


This next figure shows the journey of the treasury yield curve since the Federal Reserve started tightening in the summer of 2004--beginning a slow ascent from the bottomed-out 1% federal fund rate--and takes us to the beginning of August 2007. During this time the yield curve is flattening--the long end is not proportionally moving up, if at all, with the short end. One famous observer called these developments a a 'conundrum'. Others simply viewed these developments as the yield curve beginning to point to a slowing of growth or a recession. Based on the expectation theory (and assuming a stable term premium), the long rates should simply be an average of expected short rates and thus, the long rates should be a reflection of where short rates are expected to be going. If market participants expect slower growth ahead and in turn expect the Federal Reserve to respond by cutting its policy rate, then the long-term rates will decline. Consequently, the recent flattening of the yield curve, and its slight inversion at times, can reasonably be interepreted as an economic slowdown is looming.


Given where we are--slow real growth, housing recession, credit crunch, etc.--the yield curve's predictions appear to have been on the money. So now, I want to see what impact, if any, the flight to safety has had on the yield curve--has it added any noise? This next graph reproduces the treasury yield curve at the begnning of August 2007 as well as two subsequent days in this month: August 2oth, when the 1-month treasury yield hit is lowest value of the month, and August 28, the latest data point available as of this posting. What this figure shows is that the noise from the flight to safety appears to only to have had a temporary effect on the overall flatness of the yield curve. Yes, there was a drop in the short end of the yield curve as seen on August 20, but by August 28 the shape of the yield was almost identical to what it had been at the beginning of the month. The yield curve, then, appears capable of withstanding the occasional noise of a marekt panic. More importantly, however, is that the current, flat yield curve indicates we are not out of the woods yet.. hang in there!