By: Mr.Fog on Mercoledì 17 Ottobre 2007 01:19
I tassi scendono anzi no, salgono...
The Bond Un-Conundrum
October 16, 2007
By Joachim Fels & Manoj Pradhan / London
Greenspan’s puzzle… When the Fed started to tighten monetary policy in June 2004, something strange happened. The Fed raised short-term interest rates but long-term interest rates remained unchanged or moved even lower during the first 15 months of the tightening cycle. Alan Greenspan famously described this phenomenon as a “conundrum”. In his recently published book, the former Fed Chairman writes about the episode:
“I was perturbed because we had increased the federal funds rate, and not only had yields on ten-year treasury notes failed to rise, they’d actually declined. (…) Seeing yields decline at the beginning of a tightening cycle was extremely unusual.” (The Age of Turbulence, New York 2007, p.377)
.. turned on its head. Interestingly, we may now be witnessing a conundrum turned upside down. Since the Fed’s 50 basis point rate cut on 18 September – the first in what will presumably be a series of cuts – long-term bond yields have risen rather than fallen. Is this sustainable, and if so, why?
From lower term premiums.. It is useful to think of Alan Greenspan’s “conundrum” as a sudden decline in the term, or risk, premium on bonds. The term premium is the compensation in the form of a yield pickup that bond investors demand for holding a long-dated bond rather than rolling forward a short-dated bond. The term premium cannot be observed directly, it has to be estimated with a model.
We have two estimates of the term premium, one calculated by two researchers at the Fed, the other derived from our own Morgan Stanley FAYRE value model. Although the two models are very different, the two measures of the term premium are very similar. The “conundrum” shows up (see chart in full note) as the sharp drop in the term premium from mid 2004, when the Fed started to raise interest rates. Since then, the term premium has fluctuated roughly in a 0-50 bp band, against the 50-100 bp band prevailing in the prior ten years or so.
Much has been written to explain the “conundrum”. In our view, the low term premium and thus the low level of long rates reflected a combination of global excess liquidity – recall that the ECB kept rates low for much longer than the Fed, and the Bank of Japan’s official rate is still at only 0.5% -- and strong demand for bonds from countries such as China and the oil producers that rapidly built up excess savings and excess reserves in the conundrum years.
.. to higher ones. However, things have changed and could now lead to the opposite of Alan Greenspan’s conundrum: Further Fed rate cuts, as expected by our US economists and by the markets over the next six months or so, could lead to rising bond yields and term premia. Why?
First, while the Bank of Japan continues to pursue an expansionary policy, the monetary policy stance in the euro area has, on our estimates at least, turned restrictive, with 3-month Euribor standing some 75 bp above our estimate of its neutral level of around 4%. The ECB looks likely to keep rates on hold for the foreseeable future and still operates a tightening bias. So rate cuts in the US are unlikely to be accompanied by lower rates in the euro area for quite some time. This would tend to offset the impact of Fed easing on US yields.
Second, for some time now, old and new sovereign wealth funds around the world have been looking to raise their exposure to risky assets, implying that they are no longer as big sponsors of government bonds as they used to be. This alleviates some of the downward pressure on the term premium, too. Thus, the term premium is more likely to rise from its artificially depressed levels of the last several years, and the move has already started.
Last but not least, we continue to expect inflation concerns to pick up in the coming months, driven by global factors such as higher food and energy prices and, in the US, by the downward pressure on the US dollar against virtually all currencies. Against this backdrop, long-term interest rates look more likely to rise than fall, despite further rate cuts from the Fed. Welcome the un-conundrum!