Treasury myths

So that’s what it takes these days, huh? A few “bps” along the yield curve, scattered wobbles in the equity markets and a falling dollar for people to start prating about inflation scares, monetary debasement and what to do about it!

Big deal, I say. Headlines aside, the market moves we’ve seen in recent weeks are not only minute by inflation-scare standards but, actually, have little to do with inflation at all. Instead, they should be seen as part of the markets’ steady march towards normality.

Let me throw in some evidence:

The “sell-off” is global: First, the recent rise in long-term yields is not just an American phenomenon but a global one. Ten-year yields have gone up in countries like Germany, France or Canada, which haven’t yet embarked on quantitative easing (i.e. the purchase by the central bank of government bonds or other assets to reduce long-term yields and boost aggregate demand). Even Japan, which is already in deflation territory, has seen its long-term yields rise!

Sure, the rise in US yields has been larger than in those countries: Ten-year US yields have gone up 1.50% this year, i.e. more than twice the increase in European or Canadian yields.

But that’s from the absurdly low levels reached late last year, as the financial crisis deepened and investors rushed into the liquidity and “safety” of US Treasuries. So, effectively, US yields are now playing catch-up with foreign ones, as investors feel better about the health of the financial system and are beginning to look for higher returns elsewhere. The steady decline in corporate spreads, even as Treasury yields trod upwards, only confirms that view.

Misleading TIPS: Then you have the TIPS—the Treasury Inflation-Protected Securities. These are government bonds indexed for inflation. Analysts have historically looked at the difference between the yields of standard (or “nominal”) Treasuries and those of TIPS of the same maturity to derive an estimate of investors’ inflation expectations.

Since the beginning of the year, the difference between five-year nominal and real yields has “spiked” up by roughly 1.5%, prompting sounds of alert in some segments of the investor community.

But the analysis is misleading: The comparison of TIPS with nominal Treasuries is not an “apples to apples” one. There are two opposing forces affecting the yields of TIPS that make the comparison an art more than a science.

The first force is related to the uncertainty about the inflation outlook. When you invest in nominal Treasuries, the yield you require will be equal to the real interest rate plus your expected future inflation rate; but it will also include additional compensation for your (or the market’s) uncertainty about the inflation outlook. TIPS eliminate that uncertainty and therefore their yields will in theory be free of that inflation premium (i.e. lower).

The second force works the opposite way and is related to the relative liquidity of nominal Treasuries and TIPS. TIPS are less liquid that standard Treasuries and investors will therefore require additional compensation for holding on to them—a liquidity premium.

The bottom line here is that deriving the “true” inflation expectations from a comparison between TIPS and nominal yields requires disentangling these two effects—it’s not a simple act of subtraction.

If this disentanglement has been an art in the past, today it has moved well inside the borders of abstraction. The reason is that, as the crisis escalated last year, the relative liquidity advantage of nominal Treasuries became such a dominant factor that the yield investors demanded from TIPS moved above the yield of nominal Treasuries! In plain terms, not only were you getting inflation protection; you were also getting paid for it!

The decline in TIPS yields this year should therefore be seen in the context of normalization of liquidity conditions and risk appetite, rather than a “surge” in inflation expectations. Indeed, survey-based measures of inflation expectations such as the University of Michigan’s 5-year-ahead inflation expectations or the Conference Board’s 12-month-ahead number do not point to any measurable increase in expected inflation.

The dollar’s woes: The dollar’s broad-based sell-off is part of the same story: A story of normalization in liquidity conditions, appetite for risk and higher yields, and renewed investor focus on economic fundamentals. It has nothing to do with fears of monetary debasement.

The dollar surged at the height of the financial crisis for reasons largely unrelated to the health (or not) of the US economy relative to its peers: One reason was the flight to the safest and most liquid securities around, which are (still) the US Treasuries. Another was the tremendous funding pressures faced by banks.

Basically, as Lehmans collapsed, banks across the globe found themselves short of cash and, in particular, short of dollars—which had been the currency of choice for funding all the “exotic” stuff that originated in the US, like mortgage-backed securities, collateralized debt obligations and so on. Demand for dollars surged therefore, and so did the dollar’s exchange rate.

But funding pressures have been coming down. You can see that for example in the Fed’s balance sheet: Term auction credit to US banks has declined by $80 billion this year, while the Fed’s swap facilities set up to provide dollars to foreign central banks (which, in turn, lent them to their own banks so that they can meet their dollar needs) have shrunk by $370 billion.

Market indicators also point to the same direction: I’m about to get a bit nerdy here but you can look for example at the difference between the short-term interest-rate differentials between, say, the dollar and the euro as implied by exchange-rate forwards; and as implied by the LIBOR (interbank lending) market.

These should be almost equal in normal times due to arbitrage. But at the height of the crisis, as the LIBOR market shut down, investors turned to the FX markets for their dollar funding needs, creating a large spread between these two differentials that pointed to a huge premium for owning dollars. The spread has now come back to normal levels.

Given the widely known weaknesses of the American economy, and opportunities for higher returns elsewhere, it was only a matter of time before the dollar began to sell off. The gradual normalization in financial markets, together with perceptions that some foreign markets might be more resilient to the global slowdown than the US itself, prompted investors to seek to put their money at work elsewhere.

Indeed, as mutual funds data suggest, US investors have been net buyers of foreign equities for 11 consecutive weeks now. Clearly, this may not be a one-way street, and may reverse as the global economic outlook changes. But my point here is that the dollar’s recent sell-off is unrelated to putative concerns about monetary debasement.

I could keep going but I’ll stop here for brevity’s sake… with one additional point, especially for my friend Ben:

Credit conditions have been easing, even while Treasury yields are rising. Indeed, the increase in Treasury yields is partly the result of credit easing. Therefore, the case for the Fed’s Treasury purchase program, whose stated objective was “to improve overall conditions in private credit markets”, is now weaker than ever.

If Ben wants to expand the purchases beyond the original $300 billion, as some analysts have called for, he will have to find another reason. And, frankly, the only reason I can think of is “to avoid at all costs disappointing the markets”!