The yield on 10-year U.S. Treasuries has jumped 50 basis points since the start of May, leading some to speculate that the market is already starting to price in anticipation of an end to the Fed’s bond-buying program. There may be some truth to that, but it’s only part of the story.
It’s helpful to begin by looking back to when the Fed started the latest rounds of large-scale asset purchases. On November 3, 2010, the Fed announced its intention to purchase $75 B each month in long-term Treasuries through June of 2011, a measure popularly referred to as QE2. The theory was that these purchases would reduce the interest rate on those securities. But what happened over the next two months was the 10-year yield went up 60 basis points.
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That does not mean that the Treasury purchases had no effect. Most observers knew QE2 was coming well before the Fed made its official announcement. It may well be that at least some of the reduction in interest rates in the months prior to the announcement in fact reflected an anticipation of what everybody saw coming, with the effects completely priced into the bond market by the time the official announcement came.
But there’s another complication. One of the reasons that everyone expected QE2 was that we could all see for ourselves that the economy remained weak. Part of what persuaded the Fed to move, and what persuaded everybody else that the Fed was going to move, was a very weak labor market and signs of disinflation. But these same factors would also tend to depress interest rates even if the Fed didn’t buy a single bond. Some of the drop in rates in the fall of 2010 was likely caused by anticipation of QE2, but some was also due to a very weak economy.
And the effects of the QE2 itself operated through a couple of different channels. One is the direct consequences of the purchases through a portfolio-balance effect. Estimates of the size of this effect vary, but I think it was not more than 10–20 basis points. But another important tool for monetary policy is the Fed’s communication of its future intentions for the short-term interest rate– for how long is the interest on reserves going to remain at 25 basis points? The Fed can say that it plans to hold short rates down for some time. But actions speak louder than words. When the Fed is putting its money where its mouth is by buying large quantities of long-term securities, it adds emphasis to the declarations about its future intentions. This signaling of future short-term rates is another channel whereby policies like QE2 may affect interest rates.
One sees the same pattern in the figure above for the announcement on September 13 of the current bond-buying program (often called QE3). Rates dropped prior to the bond purchases, with little discernable change after the announcement itself. Again, markets anticipated the move in advance, partly because of statements from Fed officials, and partly because everyone could see signs of economic weakness in the U.S. and the recession in Europe. Maybe it was anticipation of QE3 that brought rates down, and maybe it was a weak economy that was the cause of both QE3 and lower rates.
So are we seeing the same pattern in reverse over the last six weeks with the 50-basis-point run-up in the 10-year yield? The Fed will need to stop its bond purchases at some point. Tim Duy is expecting the Fed will announce a slowdown in the rate of bond purchases at its September meeting; Bill McBride thinks it won’t be until the end of the year.
When it does announce tapering, the Fed will try to reiterate that the rise in short-term rates will still not come until much later. But just as QE3 added emphasis to the declaration of a commitment to an extended period of low interest rates on the way down, ending QE3 will tend to detract from that message as we start to look at the path back up.
And just as a weak economy was the primary reason the Fed embarked on QE3, a strengthening economy will be the primary reason the Fed ends it. And if the economy is strengthening, interest rates will be headed up, regardless of whether the Fed keeps buying bonds or not. It’s worth emphasizing that the recent rise in interest rates has been a global phenomenon, not just something seen in the United States.
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If you want to claim that the recent rise in rates is just an anticipation of what the Fed is going to do, the story has to be that the U.S. Federal Reserve is causing the whole world to move.
The alternative view is that it’s a big world out there that will ultimately force the Federal Reserve to move.
Balderdash!
There is no way that the Federal Government can cover the cost of its existing debt in a free market demanding interest rates above inflation, much less sell new debt for ongoing operating deficits. Treasury securities have become the ultimate in market manipulation.
From my perspective, the FED and the Federal Government have no stomach for the deflation necessary to make functional low interest rates feasible in a free market. The credit leverage is too high in the US to support another banking bubble. Consequently, quantitative easing will continue indefinitely primarily because there is no other alternative given the political inability to bite the bullet and suffer the pain that real deleveraging would entail.
My money is on LONG TERM FINANCIAL REPRESSION… Don’t get your hopes up dude. The game is market manipulation to dilute the Hoi Polloi’s credit holdings via interest rates below inflation. The same game as was played from the mid-1930’s until the early 70’s.
Could be partly spillover effects, mostly psychological, from Japan. (I like this one in part because of the measure of real rates; they just turned positive!) Could be a lot of money shifting out of emerging economies. Don’t know. Forecasts aren’t for stronger growth for Europe or China, but rather weaker growth particularly in the latter. So ….?
JDH,
It might be necessary to distinguish the Fed’s current quantitative easing programs – there are two different aspects of it that would have very different effects upon Treasury yields.
QE 3.0: This is the program that the Fed announced on 13 September 2012, which consists of the Fed accumulating Mortgage-Backed securities at a net rate of $40 billion per month.
QE 4.0: This is the program that the Fed announced on 12 December 2012, in which the Fed accumulates U.S. Treasury securities at a net rate of $45 billion per month. (In practice, the Fed has continued acquiring U.S. Treasuries at the same rate it established during its “Operation Twist” program, but has stopped selling off an equal value of Treasuries at the same time.)
We should therefore expect more of an impact on U.S. Treasuries from the QE 4.0 portion of the program, which the data would seem to support. That this impact would appear to be less than that for QE 2.0 might be attributable to the Fed not actually increasing its nominal rate of Treasury purchases.
Low interest rates have been attributed to a lack of demand for financing in the OECD economies.
But I could make the case that the supply of funds has been more important. China and OPEC created vast savings which lowered interest rates and created the asset bubbles in those countries which blew up in the recession (US, UK, Ireland, Greece, etc.)
China and OPEC have continued to generate impressive cash builds even post recession, suggesting that these are still an important contributing factors in today’s low interest rates.
Now, our models indicate that oil prices won’t move up too fast from here, and that oil exploration and production cost increases will outpace revenue increases (ie, net Saudi revenues will decline as a share of gross revenues). Furthermore, China seems to be pretty weak. Therefore, the question arises as to whether the global source of funds will be reduced, leading to a rise in interest rates.
I certainly wouldn’t mind an analysis of this thesis.
Indeed, a review of China’s economy and its short and medium term growth prospects would be most welcome.
Steven: “Now, our models indicate that oil prices won’t move up too fast from here, and that oil exploration and production cost increases will outpace revenue increases (ie, net Saudi revenues will decline as a share of gross revenues). Furthermore, China seems to be pretty weak. Therefore, the question arises as to whether the global source of funds will be reduced, leading to a rise in interest rates.
I certainly wouldn’t mind an analysis of this thesis.
Indeed, a review of China’s economy and its short and medium term growth prospects would be most welcome.”
Steven, my own works strongly suggests that the long-term exergetic, log-linear limit bound for growth of real GDP per capita for the post-industrial West and the rest of the world has occurred c. ’00-’05 to ’08.
I suspect that we can expect high energy costs and emerging Boomer demographic drag effects to coincide with an ongoing deceleration, or contraction, of real GDP per capita for the US, EU, and Japan, which will result in a contraction of US and Japanese FDI to Chian-Asia, which in turn will result in a contraction in growth of production and exports in China-Asia and global trade, resulting in a deceleration of global real GDP per capita and eventual contraction.
This will further reduce demand for liquid fuels with cost of production at a cyclical/secular/permanent peak in real terms and per capita, marking a permanent peak per capita for liquid fuels production, industrial production, employment, incomes, returns to capital’s share of GDP, and gov’t receipts.
High fixed costs of energy, gov’t, “health care”, public and private debt service, and associated IT infrastructure costs mean growth of real GDP per capita is no longer possible hereafter, requiring the Fortune 25-100 to 300 firms (with revenues equivalent to 40-75% to 100% of US GDP) to accelerate cost cutting via robotic and smart systems automation, consolidation of capacity (spinning off of assets, acquiring technology, and going private), and job cuts worldwide, reducing further employment, wage income, and gov’t receipts.
I anticipate that an increasing share of reported value-added (un)economic activity will occur between Fortune 25-300 firms (and concentrated increasingly to Fortune 10-25 over time) and the US gov’t, including transfers, credits, and subsidies for war, “health care”, the domestic “security” apparatus, energy, and agribusiness.
IOW, “Limits to Growth” (LTG) have arrived coincident with the onset of the post-growth, post-Oil Age epoch for rentier capitalism, popular (or not) representative governance, the imperial corporate-state, and the human ape species.
As for China, one should expect the structural drag effects of the “middle-income trap”, high liquid fuels costs to GDP and per capita, and Chinese Boomer demgographics to cap the rate of real GDP per capita for China-Asia, with a once-in-a-lifetime credit and banking system crisis ahead, resulting thereafter in the emergent new generation of PLA generals in Beijing asserting themselves during a period of economic, financial, social, and political crises in the years ahead.
China is a four-letter word: “sell”.
And now for the hard part. Buying bonds was easy. Liquidating a 4trln balance sheet and/or holding a negative carry position (i.e. paying high IOER vs. receiving lower coupons on long dated assets) is a lot harder.
When it does announce tapering, the Fed will try to reiterate that the rise in short-term rates will still not come until much later.
This word “tapering” is causing all kinds of confusion. Tim Duy has written a lot about the ambiguity of this word. How is announcing “tapering” any different from announcing that there will be an announcement about “tapering”? How does the Fed describe “tapering” in a way that investors don’t hear “pulling the plug”?
The alternative view is that it’s a big world out there that will ultimately force the Federal Reserve to move.
So to amend your NCAA bracket motto…Don’t bet against the world.
But another important tool for monetary policy is the Fed’s communication of its future intentions for the short-term interest rate– for how long is the interest on reserves going to remain at 25 basis points?
I think you’re right in saying that the portfolio balance effect was never more than a second or third order mover. But yet Bernanke, who is clearly a very smart guy, gave a speech peddling the portfolio balance effect as the supposed transmission mechanism for lowering rates. I always interpreted Bernanke’s remarks along the lines of a “noble lie.”
Speaking of China:
http://www.telegraph.co.uk/finance/china-business/10123507/Fitch-says-China-credit-bubble-unprecedented-in-modern-world-history.html
http://www.telegraph.co.uk/finance/economics/9794936/Food-price-rise-pushes-up-China-inflation.html
http://www.telegraph.co.uk/finance/china-business/9807052/Foreign-investment-into-China-drops-to-lowest-level-since-2009.html
China’s credit and fixed investment bubble as a share of GDP is unprecedented in world history (with the possible exceptions of the Egyptian pyramids and The Great Wall), surpassing the Japanese bubble era and that of the US during the tech bubble in the ’90s and unreal estate bubble in the ’00s.
China’s credit bubble is a black hole for the global financial and economic system that is getting wider and deeper with each passing month. The world financial system and economy is edging closer to the event horizon, i.e., point of no return.
But the Chinese can thank the Fortune 25-100 firms for their $4 trillion in FDI invested in China-Asia since the early to mid-’90s (since NAFTA) to develop offshore production and follow-one capital and consumer goods markets within Asia. Had it not been for the US and Japanese supranational firms’ FDI over the past 20 years, China would still largely be a pre-industrial economy and society today.
But China and India are 40-80 years too late to the auto- and oil-based mass-consumer (un)economic model of development with the price of oil at $95-$110 vs. $10-$12 when the US and Japan developed into industrial and increasingly post-industrial, hyper-financialized economy DEPENDENT UPON cheap Asian production.
China will grow old before growing rich . . . and western. But we’ve been here before, e.g., 1780s-90s, 1840s-50s, 1890s, and 1940s, but not with the peak of the production and supply of the primary global energy resource and 7 billion human apes on the planet.
The rise in ten years has coincided with the massive unwind of the “short yen, long JAP equity” Trade. I’m inclined to think the recent move in yields has been more a consequence of short term investment flows than anything fundamental.
The world bank just reduced global growth estimates. China is languishing. Other emerging markets are weakening. The US economy has no inflationary pressure. My bet is that this recent move will unwind fairly soon.
JDH wrote:
On November 3, 2010, the Fed announced its intention to purchase $75 B each month in long-term Treasuries through June of 2011, a measure popularly referred to as QE2. The theory was that these purchases would reduce the interest rate on those securities. But what happened over the next two months was the 10-year yield went up 60 basis points.
Wouldn’t “Occam’s razor” tell us first to simply consider that the FED analysis was wrong? Why try to jump through econometric hoops to prove them right? I realize that here found their economic beliefs on the same principles as the FED uses but what will it take for you to say maybe they are just wrong?
The JDH wrote:
And just as a weak economy was the primary reason the Fed embarked on QE3, a strengthening economy will be the primary reason the Fed ends it. And if the economy is strengthening, interest rates will be headed up, regardless of whether the Fed keeps buying bonds or not. It’s worth emphasizing that the recent rise in interest rates has been a global phenomenon, not just something seen in the United States.
Doesn’t this just add more evidence to an “Occam’s razor” conclusion?
Finally, if it is as simple as the FED being wrong, why should be believe any rationale for other policies?
If the “strengthening economy” is more hype and illusion and many of us believe, aren’t we staring disaster in the face if the FED acts as if it is strengthening when it is not? But then we have to consider that previous monetary and fiscal decisions have put is into a position that any action by the FED is going to lead to problems.
If we want recover it must come from the fiscal side not the monetary side and that means congress and a president who know what they are doing. Good Luck!
Whatever the cause here are some other assets that moved in lock step with securities:
Mortgage rates jumped by about the same as treasuries.
Junk bond yields rose by more than twice as many basis points at treasuries.
The Ishares Real Estate ETF dropped more than 10%.
The S&P 500 lost around 2.5%.
The 10 year treasury was more sensitive to the move than the 30 year treasury. Longer dated bonds are supposed to be more sensitive to interest rate changes than 10 year bonds, so the implication is that these moves were related to speculators, traders, and fund managers.
No price change that happens over “the next two months” should be attributed to the predictable result of an event that happened in the previous two months because markets are not stupid enough to let you make such easy profits. Whatever price change has happened in the last two months must be due to changes over the last two months in the market’s future expectations, not the lingering yet predictably mechanical effect of something that happened two months ago.
I also think Scott Sumner would tell you that expectation of more bond-purchasing should raise interest rate expectations by increasing expectations of economic growth and money supply growth, but I’m not Scott Sumner so I’m not sure.
$98 oil at the given oil consumption to GDP and yoy rate of increase from $88, the 2% higher payroll tax increase on wages/salaries, and the yoy contraction in US gov’t spending at the given share of GDP is resulting in a net annualized reduction of ~1.6% from nominal GDP.
Historically, this is akin to the net effect of the Fed raising rates for the cycle and more than enough to result in a recession.
At the trend rate of nominal GDP at just over 2% since ’07-’08, and 0% to slightly negative real per capita, the US economy is at a perpetual stall speed and at an ongoing risk of contraction.
The ~0.3% contribution from the housing sector to GDP is more than offset by the cumulative effect of the decline yoy in gov’t spending, the higher price of oil, and the increase in the payroll tax.
https://www.box.com/s/x2uoagl2or7hu49tp6br
https://www.box.com/s/bms6q1wjzvcvsv7ums95
With the yoy change rates of real imports contracting and US real GDP below 2%, the 3- and 6-month annualized change rates of ECRI’s USCI suggest that US real GDP has been at increasing risk of a marked deceleration into contraction since the beginning of the year.
Thus, the S&P 500 in terms of the 6- and 10-year PEG, including the current yoy contraction in reported earnings, is as overvalued as in 2007, 2000, 1987, 1973, and 1930.
It is no coincidence that the largest stock market crashes in history have occurred from similar levels of overvaluation with reported earnings contracting yoy.
Under these conditions and the implications hereafter, there is a zero probability that the banks will cease printing themselves via the Fed hundreds of billions of dollars’ worth of free reserves.
Actually the Fed often moves global rates. It produces the main global reserve currency so there’s nothing outlandish about that. The big world is actually slowing outside the US, mainly, or in a recessionary rut. It would be very hard to point to developments outside the US driving up rates.
Also it’s important to differentiate short and long rates. The latter are much more sensitive to changing estimates of future Fed policies.
You ‘all matriculated at the wrong schools. Rates went up as the roc in MVt went up. It’s been that way for 100 years now.
Steven Kopits,
Bruce seems to forecast economic decline or at least sluggishness. You seem to believe that the price of oil will not grow significantly. I concur.
That being the case, why is oil currently increasing in price? It is higher than it has been since last summer.
Ricardo: “[W]why is oil currently increasing in price? It is higher than it has been since last summer.”
Ricardo, see the following:
China’s oil imports:
http://au.ibtimes.com/articles/442564/20130306/china-world-s-top-oil-importer-beating.htm#.UcDfSZy2Y1I
Iran’s oil exports:
http://www.reuters.com/article/2013/06/06/us-usa-iran-oil-idUSBRE95506F20130606
http://www.eia.gov/countries/cab.cfm?fips=IR
Iraq:
http://www.eia.gov/countries/cab.cfm?fips=IZ
Imports for China, Japan, and India:
http://www.eia.gov/countries/cab.cfm?fips=CH
http://www.eia.gov/countries/cab.cfm?fips=JA
http://www.eia.gov/countries/cab.cfm?fips=IN
Canada:
http://www.eia.gov/countries/cab.cfm?fips=CA
Saudi Arabia:
http://www.eia.gov/countries/cab.cfm?fips=SA
Russia:
http://www.eia.gov/countries/cab.cfm?fips=RS
Which countries are the largest consumers of Iran’s oil exports? Where will these countries find supplies to make up for losses from an Iranian oil export blockade/embargo?
Which oil-exporting countries have any excess export capacity to cover the shortfall?
Which country is the US on the hook for to be paid back in oil revenues for imperial treasure expended over the past decade?
http://www.eia.gov/todayinenergy/detail.cfm?id=11691
BTW, US crude oil production at 10Mbb/day in 2040 at the trend population rate would be a 42% decline per capita from the peak in 1970 compared to a 53% decline today, a net increase per capita of 0.5%/year over the next 27 years. This is compared to the 4.6%/year rate from 1920 to 1970.
Adjust the 0.5% rate of increase per capita by the regression of the necessary constant-dollar price of oil required to sustain investment, extraction, and profits, and the price of oil needs to increase to $200-$250/bbl by 2030-40. Thus, US oil production is likely to experience a limit bound around 5-6Mbbl/day.
https://www.box.com/s/urkg7lqju0xz348shf2p
https://www.box.com/s/gb8m6ur7zwfzflrwurw0
https://www.box.com/s/eaf5i10v8lf8xdbrynvv
However, real GDP per capita cannot grow with the price of oil above $35-$40/bbl, and growth contracts above $70-$80/bbl.
https://www.box.com/s/5dqe1l2j8r2gg9g99mot
And that’s a serious structural problem because the continuing growth of profitable US and Canadian oil production is likely to require the price of oil above $90-$95/bbl.
Therefore, at the price of oil in the $80s-$100s, US and Canadian production is likely peaking due to decelerating rate of growth of demand worldwide, because the rate of US AND world real GDP per capita can no longer grow.
So, we can’t have our deep, tight, and tar sands “oil” and substitutes AND grow real GDP per capita with the price of oil above $35-$40/bbl. IOW, growth of real GDP per capita and profitable expensive “oil” are not compatible: Peak Oil and “Limits to Growth” have arrived.
Bruce,
I am with you on most of what you say but I think your estimates of anything above $35-$40 restricting GDP are dated. That was a good number 15 or so years ago but the more recent debasement of the currency has shifted that amount higher. I believe that Steven has estimated that current production break even costs are close to that amount.
Concerning the price of oil, in a free economy it doesn’t make a lot of difference what the price is. It simply becomes a cost of production and entrepreneurs and traders will adust as necessary. It only becomes an issue in a top down command economy when bureaucrats attempt to guess at numbers and price points, then distort price signals.
http://www.imf.org/external/pubs/ft/fandd/basics/dutch.htm
http://www.nakedcapitalism.com/2013/05/richard-alford-the-dutch-disease-and-once-and-future-economic-crises-in-the-us.html
Ricardo, peak US domestic oil production in 1970-85 (after 4.6%/yr. growth from 1920 to 1970), the 55% decline per capita since, and the resulting deindustrialization and hyper-financialization of the US economy is classic imperial “Dutch Disease”.
The world is now where the US was in the mid- to late 1970s with the price of oil well above the level at which world real GDP per capita can grow.
Don’t take my word for it. Look at the change rates per capita for crude oil production and real GDP.
The US economy cannot grow real GDP per capita with the price of oil above $35-$40/bbl, and the world is now reaching the limit bound for real GDP per capita after a 10% decline per capita in crude oil production since 2005 and a tripling of the average price of oil.
It makes ALL THE DIFFERENCE what the price of oil is and why one can predict with confidence that US and Canadian crude oil and liquid fuels production is peaking along with world real GDP per capita growth (and increasing risk of contraction).
Thus, we are likely to see US oil production back to the 5-6Mbbl/day range during the next recession.
Bruce,
I don’t question your facts at all. Your research is sound and you present it with honesty. I do analyze it differently than you do.
BP has just released their Annual Statistical Review of World Energy.
There has been a 60% increase in proven global oil reserves in the past 20 years and since 1980s reserves are up 144%. It is difficult to find a commodity with that kind of supply growth. So I don’t really believe that we are in an oil supply crunch. Our economic problems are much broader.
“And now for the hard part. Buying bonds was easy. Liquidating a ($4 trillion) balance sheet …. is a lot harder.”
And exactly.
In part owing to the fed’s policy of running down the dollar and improving the U.S. international competitive position, (which I think is the biggest real effect of QE), events in ROW, and in particular the euro area, may give us another ‘shock’ for which more QE may be an ineffective poultice.
Well, whatever was driving up rates before today, it seems obvious that today’s rates move was driven by Bernanke.
The only small room for debate is over how much of the move was driven by his comments on likely future policy and how much was driven by his announcement of Fed economic forecast revisions.
Ricardo –
The oil price has been languishing recently around $103. It’s currently around $104–much in the range it’s been recently.
Our view of the carrying capacity of the US is around $100 (Brent), and recent consumption statistics support this notion (with the caveat that oil producers get to consume more oil).
We have called the support price for around $105 Brent. So we’re in that range, but weaker than we’d expect.
There are two possible explanations:
1. China is weak.
China is weak, and wouldn’t it be great if we knew as much about China as we do about Wisconsin.
2. The long-run carrying capacity of the global economy is lower than the short-run carrying capacity.
Thus, we put carrying capacity of the US at around 4% of GDP, but in truth, it’s never stayed there historically. By itself, assuming no supply constraints, it will retreat to about 2.5-3.0% of GDP. This would imply a carrying capacity in the $75-80 Brent range in the long run.
Personally, I don’t believe it (due to the impact of growing Chinese consumption), but it’s not an argument to be readily dismissed.
Ricardo,
3/4 of the huge “proved oil reserves” tabulated by BP consist of political fantasy numbers from OPEC countries, and most have no basis in reality known to outsiders. Many are patently false. Venezuela’s took several enormous y.o.y leaps to keep up with Chavez’ ego. Saudi’s have been essentially (and impossibly) unchanged for years, after a sudden doubling when OPEC instituted quotas based on claimed reserves. And so on. You are in a dream world.
Steven,
Thanks! Good info and I would not argue at all with your estimates of Brent.
To me WTI has been over-priced. After Bernanke’s speech it has crashed. That is good news for me becuase I was significantly short. It appears that it will continue to decline.
I do not see this as much concerning oil supply and demand as I do the economic environment. We are headed for a serious economic decline and oil is a leading indicator for the economy, as gold is a leading indicator for oil.
@Posted by: don at June 19, 2013 12:26 PM
“”And now for the hard part. Buying bonds was easy. Liquidating a ($4 trillion) balance sheet …. is a lot harder.”
And exactly.”
Well Don, it has already been decided that Janet Y. will do this job (my ex-buddies at GS told me) – it’s a housewife cleaning business.
Hohannes,
I understand that Yellen is planning to clean the economy out with a firehose pumping money.