There never was a bond market “conundrum”

Here is Alan Greenspan in Testimony February 16 2005:

“Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short- term interest rates are normally accompanied by a rise in longer-term yields… For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.”

Back in 2005 there was lot of talk that bond yields was “too low” and Greenspan certainly contributed to the discussion of this “conundrum”.

Do you know what? There was really no conundrum. Today, seven years later we can actually see that long-term bond yields were too high rather than too low. How do I know that? Well, a (overly?) simplified calculation will show that. In 2005 5y and 10y bond yields were around 4%. Basically a 5 or 10-year bond is actually a collection of shorter-term bonds – for example 5 or 10 1y bonds.

So what have the average yield on 1-year US bonds been since 2005 until today? 2.5%! This is well below 4% that 5 and 10-year bonds were yielding in 2005.

Had Alan Greenspan been a Market Monetarist he might have said 2005 that “We have increased interest rates by 150bp in recent months and as a result inflation expectations are well-contained and as a result long-term bond yields are just around 4%. In fact as we are targeting a 5% growth path for the nominal GDP level there is a chance that we have overdone the tightening.”

Greenspan instead questioned the market’s judgement. The market was too optimistic on US NGDP growth, but not as extremely optimistic as Greenspan.

Believe it or not the market (at the least the bond market) was really forecasting quite a sharp slowdown in NGDP growth. So who says the market isn’t efficient?

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  1. cthorm

     /  January 17, 2012

    >In 2005 5y and 10y bond yields were around 4%. Basically a 5 or 10-year bond is actually a collection of shorter-term bonds – for example 5 or 10 1y bonds.

    I agree with your conclusion (inflation expectations were being lowered by Greenspan’s rate hikes), but this quotation is taking “basically” to the extreme. It’s like saying “cocoa futures are really a collection of sugar and canola oil spot prices.”

    Yes, a 10 year bond can be split up and sold as 10 1 year bonds or any conceivable combination of those cash flows. This is common practice among bond investors. That does not mean that the 10 year bond is really the same as it’s constituent cash flows, especially when you’re talking about inflation. The inflation premia is (usually) higher for longer duration bonds; 10 1yr bonds will necessarily have smaller inflation premia because the yield only reflects a 12 month term.

    • Cthorm, you are of course right that this is a highly simplified way of looking at it, but it does not change the fact that the market was more right about the outlook for NGDP than Greenspan & Co.


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