Economics, Politics, Social Commentary and occasionally Superstring Theory.

Thursday, December 09, 2004

Bad Moon Rising

The Financial Times has it that weak demand for ten year T-Bonds has pushed yields up by five basis points. This might be a good time to explain how the bond market works:

When the U.S. government (or anyone, for that matter) decides they want to borrow money from the public at large, they have a number of different options. One way is to issue bonds. The U.S. Treasury issues what are called 'zero-coupon bonds.' This means they don't pay out a stream of money over the life of the bond (or coupons.) Instead, they offer bonds at less than face value which are redeemable at some other point in time for full face value. This is like asking a friend for an IOU: "Hey, Mike, if you buy me lunch today I'll take you out to dinner next week." Dinner normally costs more than lunch, so most friends would go along. Buying bonds is the same thing. When you make this offer, however, you don't know where your friend is going to pick for dinner. You may get lucky, and he might decide he just wants a peanut butter sandwich. Or, he might decide he wants dinner at Spago's. People buying bonds are depending on the sandwich answer, because then they realize a gain. (Lunch out typically costs more than peanut butter and a couple of slices of bread.)

What determines the Spago's v. sandwich decision in the bond market is not your friend's preferences, but the rate of inflation. How much the face value of the bond is discounted depends on what the buyers' consensus of future inflation will be. If a bond will pay me $100 in ten years for a price today of $60, that might sound like a good deal. But if my present $60 is going to be worth $120 in ten years, then I've actually lost money. Typically, if the bond issuer does not get enough to demand, they have to raise yields. What this really means is that they're lowering the price (if this sounds counter-intuitive, it is.) Let's go back to our dinner example. Let's say you're asking your friend for another IOU. "Nope," Milke says. "I got burned by you one time before. You said you would buy me dinner, and then tried to pass off that sandwich as payment." Well, now you're either going to have go lunch-less or sweeten the deal (maybe with dinner and dessert.) When bond yields go up (and bond prices go down), the bond issuer is sweetening the deal by offering a deeper discount for a guaranteed payment at some point in the future. If the issuer discounts the bonds too much, then the bearer gets a pot of money at the end of the bond term, or maturity. If the issuer discounts the bonds too little, then the issuer gets the gain. At the end of the day, the bond market is an attempt by people to predict the future and capitalize off of what they believe to be misconceptions.

Given the above, the bond market should be an accurate predictor of future inflation. After all, you have all these savy traders who make a living off of trading these things and staying immersed in the current economic data. Well, you'd only be partially right. It gets trickier when the bonds are government bonds. While they are viewed as the safest investment, actors sometimes have ulterior motives in buying and selling bonds. This takes us to central banks and the currency market. It took about twenty times of reading this stuff to make me understand it, but a good maxim to keep in mind is the following: The value of something is directly dependent upon its scarcity. Grains of sand are everywhere, not very valuable. Gold is not everywhere, very valuable (sometimes.)

This goes for currency, too. The more dollars out there, the less valuable it is against other currencies. But how do more dollars get out there? The U.S. Treasury issues bonds. The more bonds it issues, the more dollars (theoretically) that are in circulation. So, why would the Treasury be issuing all these bonds if all it does is make the dollar less valuable. This is where deficit spending comes in. The U.S. government has to pay its bills somehow. And when its income doesn't meet its expenses, it has to borrow, just like everybody else. Typically, this has the effect of raising bond yields. Why? Remember, the value of something is dependent upon its scarcity. So, if we assume there's a finite amount of money out there to be borrowed, the less there is, the more expensive it gets to borrow it. Let's go back to our lunch example. You still want Mike to buy you lunch, but you've had to offer him dinner at McDonald's to get him to even consider it. Unfortunately, Mike is the only one of your friends who has any money, and a bunch of your friends want him to buy them lunch, too. Mike can only afford to buy one person lunch. So, a bidding war ensues. Mike will buy the person lunch who 1) makes the most lucrative offer and 2) has the most potential of fulfilling that offer. This is what happens in the bond market. In order to attract people to buy the bonds, the issuer has to offer lower prices that reflect the scarcity of available capital. So, if the government is in a record deficit (which it is) bond prices should be falling, yields should be rising and the dollar should be losing value. However, they aren't. Why not? Remember: more bonds = higher yields = lower bond prices = more dollars = less valued dollar.

Because actors in the market aren't making decisions purely out of self-interest. Central banks are typically large institutions that belong to or are controlled by governments. The Federal Reserve is the U.S. central bank. Because these banks are either de facto or de jure controlled by their host governments, they sometimes act in the interest of the government rather than the bank. For instance, Japan and South Korea's export markets are very sensitive to U.S. demand for their exports. The most direct way to value a currency is to measure its value against other currencies. A dollar that is declining in value means that their exports get more expensive. How? Because their exports are valued in their own currency. If the dollar will buy 1 won on Tuesday, but only 1/2 of a won on Wednesday, whatever I'm buying has just become more expensive if its valued in wons. Let's say that I want to buy a Sony Discman which is made in Japan. It costs Sony 1000 yen to produce the Discman, get it to the U.S. and realize a reasonable pocket. I, however, do not get paid in yen. I get paid in dollars. So, I will have to exchange my dollars for yen to buy the Discman (this will be done for me by the importer.) If the dollar has lost value, then the functional impact to me is that the Discman has become more expensive. So, I might decide to take a look at a Phillips brand instead (provided it is made in a U.S. dollar-denominated currency country.) Because the Phillips brand is made with its value denominated only in dollars, and it never has to be exchanged for a stronger currency, the Phillips brand Discman will be cheaper. And I will buy it. A falling dollar therefore makes foreign exports more expensive, driving down demand for them here in the U.S. So, central banks that are linked to governments that have export markets particularly sensitive to U.S. demand have the most to lose from a falling dollar. But what does all of this have to do with the bond market?

Hopefully, you're beginning to see the picture now. Central banks with strong U.S. export markets will intervene to prop up a dollar that is on the decline. Why? If the U.S. government is in record deficit territory, with no real end in sight, why buy bonds when the prices don't reflect the risk? Part of this is because there is no real risk that the U.S. will default on its bonds. It is the economic superpower, and its word is generally risk free. Remember criterion number 2 from the lunch example: Mike will lend to the person who has the greatest potential to actually deliver on their promise. If you offer Mike a lamborghini next week and have no job, and John offers him a steak dinner and has rich parents, which do you think he'll pick? Being the dominant economic power allows the U.S. to avoid some of the risk premium it would have to offer were it another country running the deficits that it is. But this only accounts for some of the irregularity. Bond prices should still be at record lows, with yields at record highs. The other reason is blanket self interest. A strong dollar is in the interests of governments who's economies are sensitive to U.S. demand for their exports. A drop in the dollar means a drop in demand. So, these banks will often buy undervalued bonds just to keep the dollar from sliding further. Because the banks generally buy through indirect buyers, so as to keep their motives secret, no one knows exactly how much they are buying for sure. But they are buying.

So, where does that leave us? central banks bought up the majority of the last two major bond issuings by the Treasury. We know central banks have incentives other than self-interest to buy these bonds. Those incentives lead them to push for an (over)valued dollar. Their buying resources cannot (ordinarily) be matched by the private sector. Conclusion: The central banks have propped the dollar up above its actual value. In doing so, they have depressed bond yields and inflated bond prices. Whether they can do this sustainably is open for debate. If they cannot, get ready for another global recession.

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