If there is a ‘bond bubble’ – it is a result of excessive monetary TIGHTENING

Among ‘internet Austrians’ there is an idea that there is gigantic bubble in the global bond markets and when this bubble bursts then the world will come to an end (again…).

The people who have these ideas are mostly people who never really studied any economics and who get most of their views on economics from reading more or less conspiratorial “Austrian” school websites. Just try to ask them and they will tell you they never have read any economic textbooks and most of them did not even read Austrian classics as “Human Action”. So in that sense why should we worry about these views?

And why blog about it? Well, because it is not only internet Austrians who have these ideas. Unfortunately many central bankers seem to have the same kind of views.

Just have a look at this from the the Guardian:

A key Bank of England policymaker has warned of the risks to global financial stability when “the biggest bond bubble in history” bursts.

In a wide-ranging testimony to MPs, Andy Haldane, Bank of England director of financial stability, admitted the central bank’s new financial policy committee is taking too long to force banks to hold more capital and appeared to criticise the bank’s culture under outgoing governor Sir Mervyn King.Haldane told the Treasury select committee that the bursting of the bond bubble – created by central banks forcing down bond yields by pumping electronic money into the economy – was a risk “I feel acutely right now”.

He also said banks have now put the threat of cyber attacks on the top of their the worry-list, replacing the long-running eurozone crisis.

“You can see why the financial sector would be a particularly good target for someone wanting to wreak havoc through the cyber route,” Haldane said.

But he described bond markets as the main risk to financial stability. “If I were to single out what for me would be biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally.” he said. There had been “shades of that” in recent weeks as government bond yields have edged higher amid talk that central banks, particularly the US Federal Reserve, will start to reduce its stimulus.

“Let’s be clear. We’ve intentionally blown the biggest government bond bubble in history,” Haldane said. “We need to be vigilant to the consequences of that bubble deflating more quickly than [we] might otherwise have wanted.”

I must admit that I am somewhat shocked by Haldane’s comments as it seems like Haldane actually thinks that monetary easing is the cause that global bond yields are low. The Bank of England later said it was not the view of the BoE, but Haldane’s “personal” views.

If Haldane ever studied Milton Friedman it did not have an lasting impact on his thinking. Milton Friedman of course told us that low bond yields is not an result of easy monetary policy, but rather a result of excessively TIGHT monetary policy. Hence, if monetary conditions are tight then inflation and growth expectations are low and as a consequence bond yields will also be low.

Hence, Milton Friedman would not be surprised that Japanese and US bond yields have risen recently on the back of monetary easing being implemented in the US and Japan.

In fact the development in global fixed income markets over the past five years is a very strong illustration that Friedman was right – and why Haldane’s fears are misguided. Just take a look at the graph below – it is 10-year US Treasury bond yields.

10y UST

(If you think you saw this graph before then you are right – you saw it here).

If Haldane is right then we should have seen bond yields decrease following the announcement of monetary easing. However, the graph shows that the opposite have happened.

Hence, the announcement of TAP and the dollar swaps lines in early 2009 was followed by an significant INCREASE in US (and global) bond yields. Similarly the pre-announcement of ‘QE2′ in August 2010 also led to an increase in bond yields.

And finally the latest sell-off in the global fixed income markets have coincided with monetary easing from the fed (the Evans rule) and the Bank of Japan (‘Abenomics’)

If you think there is a bond bubble

then blame the ECB’s rate hikes in 2011

Looking at US 10-year yields over the past five years we have had three major “down-legs”. The first down-leg followed the collapse of Lehman Brothers in October 2008. The second down-leg played out in the first half of 2010 following the hike in Federal Reserve’s discount rate in February 2010 and the People Bank of China’s increase in the reserve requirement in January 2010.

However, the biggest down-leg in US 10-year bond  yields followed the ECB’s two rate hikes of 2011 (April and July). Believe it or not, but the ECB was “able” to reduce US 10-bond yields more than the collapse of Lehman Brothers did.

Hence, if there is a ‘bubble’ in the global fixed income markets it has not been caused by monetary easing. No if anything it is a result of excessively tight monetary conditions.

In fact it is completely absurd to think that global bond yields are low as a result of central bank ‘manipulation’. Global bond yields are low because investors and households fear for the future – fears of low growth and deflationary tendencies. Global bond yields are low because monetary policy have been excessive tight.

Rejoice! Yields are rising

Unlike Andy Haldane I do not fear that day the bond ‘bubble’ (it is not a bubble!) will burst. In fact I look forward to the day US bond yields (and UK bond yields for that matter) once again are back to 5%. Because that would mean that investors and households again would believe that we are not heading for deflation and would once again believe that we could have ‘normal’ GDP growth.

And unlike Haldane I don’t believe that higher bond yields would lead to financial armageddon and I don’t believe that Japan will default if Japanese bond yield where to rise to 3 or 4%. Banks and countries do not go belly up when growth takes off. In fact the day US bond yields once again is back around 5% we can safely conclude that the Great Recession has come to an end.

Concluding, there is no ‘bond bubble’ and Andy Haldane should not have sleepless nights over it. The Bank of England did not cause UK yields to drop – or rather maybe it did, but only because monetary policy has been too tight rather than too easy.

PS I never heard any of these ‘bubble mongers’ explain why Japanese property prices and equity prices have been trending downward for nearly two decades despite interest rates being basically at zero in Japan.

PPS the graph above also shows that “Operation Twist” in 2011 failed to increase growth and inflation expectations. Any Market Monetarists would of course have told you that “Operation Twist” would fail as it did nothing to increase the money base or increase the expectation for future money base expansion.

—–

Related posts:

When US 30-year yields hit 5% the Great Recession will be over
Confused central banks and the need for an autopilot
Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman)
Tight money = low yields – also during the Great Recession

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9 Comments

  1. Benjamin Cole

     /  June 17, 2013

    Excellent blogging.

    As pointed out in this post, for many reasons the “bond bubble” hysterics just don’t make sense, especially for government bonds, where the risk of default tis nil.

    Government bonds will always pay off. They offer secure yield and safe principal.

    Government bonds can only do down in value so much. This is unlike property or equities, where the bottom can be anywhere current hysteria or gloom places it.

    The world faces a menace today: Central bankers who cannot understand their job now is economic growth, not inflation fighting.

    Reply
  2. JN

     /  June 17, 2013

    Lars, interesting post.

    A few comments however:
    - I don’t believe the situation is as straightforward as you imply. Rising or decreasing bond yields can mean different things depending on the situation in my opinion, despite what Milton seems to have said. Bond yields could rise as inflation expectations rise. It doesn’t mean (real) growth expectations rise necessarily (see the 1970s/1980s). On the other hand, decreasing bond yields can also happen when growth expectations increase as inflation decreases (post 1980s, with of course some volatility).
    - As a result, it looks difficult to me to take the evolution of yields just by themselves to reach any conclusion. In my opinion, easy or tight monetary policy could be identified also looking at lending growth. If lending growth is fast, then it might mean that market participants think that the financing conditions are good or “worth it” (comparing their cost of funding to potential projects returns). This is probably something to look at in parrallel as the yield curve.
    - Even if inflation expectations increase, central banks still have the power to partially offset a rise in yields. Then your indicator becomes slightly faulty.

    A quick note on “Internet Austrians”. I heard this term a lot recently. I’m still waiting to see criticisms towards “Internet Keynesians” though.

    Reply
  3. Lars,
    Don’t know if you saw this gem from Charles Plosser of the Philly Fed:
    “When governments don’t work, people are out of work, economies aren’t growing, easy money turns out to be the easy thing to do. It’s the one thing that governments can do because they can’t simply do what they’re expected to do. And it’s dangerous. In a funny sort of way, and you’re not going to like this, central banks around the world have become something of enablers of dysfunctional democratic systems. And the day of reckoning will come and all of you have got to think about it. And that’s the great unwinding. It will happen here, it will happen around the world…It’s easier to print money than it is to raise taxes or cut spending. And when that happens, we know that that usually ends in a not very pretty place. And I think that it’s very dangerous for us to think that monetary policy is a solution.”

    Reply
    • Thanks Chris,

      It seems like Charlie Plosser and Richard Fisher will oppose monetary easing for whatever reason they can find. I can certainly understand the fear that the fed becomes a instrument of government to fund public spending, but monetary easing is “dictated” by the state of the US economy. But I know you agree on that…

      Reply
  4. Takashi

     /  June 19, 2013

    Hello,
    I’m writing this from Japan. Yes, in Japan, there are similar people who are clamoring against rising nominal bond interest rate because, they say, it could lead to government default. But the problem is that they have some influence in Japan.
    Of course, they admit that when the economy is recovering, nominal bond interest rate is also increasing. But they think that before, when, or even after, the economy recovers, Japanese default could happen. The reason is that because a lot of banks have huge amount of Japanese govenment’s bonds (it is true), the depreciation of them caused by rising nominal interest rate would make many of them go bankrupt.
    You might think it is strange. The value of a bond won’t change when it matures. But according to Japanese accounting system, a bond is accounted as its present value. So as nominal bond interest rate is increasing, the wealth of a bank is decreasing. Therefore, they say, it could lead to bankruptcy.
    Otherwise, they also argue, avoiding this case, many banks all of sudden would be panicked to sell the bonds they are holding when they see nominal bond interest rate is rapidly rising, and this, in turn, could lead to a collapse of Japanese bond market.
    Is this story convincing?

    Reply
  1. What damage a few words can do! | Historinhas
  2. The presumption of US resumption of growth | The Corner The Corner
  3. Celebrating Friedman and Hetzel | The Market Monetarist
  4. There is no bond market bubble | The Market Monetarist

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