Understanding financial markets with MV=PY – a look at the bond market

Recently I have been thinking whether it would be possible to understand all financial market price action through the lens of the equation of exchange – MV=PY. In post I take a look at the bond market.

The bond market – its about PY expectations

A common misunderstanding among economic commentators is to equate easy monetary conditions with low bond yields. However, Milton Friedman long ago told us that bond yields are low when monetary policy have been tight – and not when it has been loose. Any Market Monetarist will tell you that monetary conditions are getting easier when nominal GDP growth is accelerating and and getting tighter when NGDP growth is slowing. So with this Friedmanite and market monetarist insight in mind there should be a relationship between higher bond yields and higher nominal GDP growth. Hence, when market participants expect MV to increase then we should also see bond yields increase.

The graph above shows the correlation between 10-year US bond yields and US NGDP growth. The graph illustrates that there is a fairly close correlation between the two series. Higher bond yields and higher NGDP hence seem to go hand in hand and as we know MV=PY we can conclude that higher bond yields is an indication of looser monetary policy. Furthermore, we should expect to see bond yields to increase – rather than decrease – when monetary policy is eased. Or said in another way – any monetary action that does not lead to an increase in bond yields should not be considered to be monetary easing. 

Therefore, given the present slump we are in we should not be worried that rising bond yields will kill off the recovery – rather we should rejoice when long-term bond yields are rising because that is the best indictor that monetary conditions are becoming easer and that that will push up nominal GDP.

The brief discussion above in my view confirms some key market monetarist positions. First, financial markets are good indicators of the stance of monetary policy. Second, monetary policy works through expectations – with long and variable leads. Third low bond yields is an indication that monetary policy has been tight and not that it is loose.

UPDATE: In my original post I had used some wrong data. Clare Zempel kindly notified me about the mistake(s). I am grateful for the help. As a consequence of the wrong data I have revised part of the original text.

UPDATE 2: David Beckworth has an excellent post arguing the exactly the same as me: “the recent rise in long-term yields can be interpreted as the bond market pricing in a rise in the expected growth of aggregate demand.”. And take a look at David’s graph showing the relationship between expected NGDP growth and 10-year bond yields. Great stuff!

Leave a comment


  1. That´s exactly what QE1 and QE2 showed! Although Scott Sumner has lately been fond of saying that Bernanke “favors” NGDPT, he always justified QEs with the argument that it would lower long rates!

    • Exactly Marcus…this idea that monetary policy should be used to kepp bond yields down does make any sense at all. In fact it likely distort market prices that otherwise might provide us with important information on whether or not monetary easing is work. And I agree the effect of QE1 and QE2 was to increase long bond yields – and that exactly shows that that it worked. “Operation twist” have not had that effect and it is therefore questionable whether it is working. The 3-year LTRO from ECB, however, has pushed up US bond yields. It is Draghi and not Bernanke who is easing monetary conditions in the US at the moment.

  2. Max

     /  March 21, 2012

    “Or said in another way – any monetary action that does not lead to an increase in bond yields should not be considered to be monetary easing.”

    Or: monetary easing should increase all asset prices *except* safe bonds.

    So what message does it send when a central bank buys safe bonds?

  3. Max, that is totally correct and as I wrote to Marcus above a policy of trying to keep bond yields low does not make any sense at all – and it is especially concerning that central banks are trying to distort market prices that might otherwise tell us where the economy is going.

  4. It is koo-koo talk to say government can force interest rates by printing money. Financial repression?

    Interest rates are low as the Fed and ECB are asphyxiating the global economy through peevishly tight money.

  5. KKB

     /  March 21, 2012

    If you look at the error terms (difference between the two curves) https://marketmonetarist.files.wordpress.com/2012/03/10ybondngdp.pngpng, the differences in % terms are non negligible.

    Secondly, the 10 year note yield is correlated with macro expectations, you buy treasuries when you think there is going to be a downturn, and sell on the upturn.

    By lagging the market expectation of future growth onto the past and then seeing a correlation it’s not only faulty statistics but it is obvious why it correlates as when people see GDP growth they sell treasuries!

  6. Treasuries are an inferior good.

  7. Clare Zempel

     /  March 21, 2012

    I respect your work but believe that the series’ names are reversed in both charts above. I attempted to duplicate them using data from FRED and noticed that it is the 10-year T-Note’s five-year average that peaked above 12% in 1984-85. This is intended to be helpful. The implication is that the T-Note’s trend has followed GDP’s trend since 1965 (and also since 1958), and not the reverse.

    • Thank you Clare. I am not to proud to admit I made a mistake so I will have a look at the data again. Thanks for the input…I will get back to you on this once I have had time to look at the data. I also used FRED.

      • Clare, I have now had a look at the data. I hate to admit it, but you are right. I had mixed up the two data series. That just proves the point why you should leave this kind of thing to research assistance!

        Thank you very much for spotting the mistake. I will naturally correct the graphs and the text asap.

  8. I’m guessing that this applies to Treasuries, and not the problem with the PIIGS. Don’t think we can look at any country and say tight money means low bond yields, point to Spain, for instance, and say that money is extraordinary loose because the yield is 6%.

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