Does the New Bond Market Conundrum Tell Us Anything? If So, What?: Tuesday Focus for September 2, 2014

The extremely-sharp Jérémie Cohen-Setton has a roundup:

Jérémie Cohen-Setton: Blogs review: The bond market conundrum redux: “Are we seeing a new version of the Greenspan 2005 conundrum?… Fed tapering was widely expected to push up US yields. Instead, US yields have fallen since the beginning of the year…. A successful explanation of this new conundrum cannot just rely on a flight to safety… it also needs to rationalize why 5-year… and 10-year yield[s] have diverged….

Jeff Sommer… David Beckworth… Marc to Market…. James Hamilton writes that as the U.S. economy returns to healthier growth, many of us expected long-term interest rates to return to more normal historical levels. But the general trend has been down…. In… 2005… Greenspan noted that long-term interest rates [had] trended lower in recent months even as the Federal Reserve [had] raised the level of the target federal funds rate by 150 basis points… [in apparent contradiction] to the expectations theory of interest rates were long rates are the geometric average of expected future short rates plus a risk premium that would usually increase with duration of the instrument….

David Beckworth uses a decomposition of the long term interest rate into an average expected real short-term interest rate, average expected inflation, and a term premium to argue that it’s the term premium has been steadily falling…. James Hamilton writes that… while the… 10-year Treasury has been falling… the 5-year yield has held fairly steady…. Something happened this year to persuade people that rates in the future (for 5 to 10 years from now) were going to be lower than they had been expecting. Robin Harding and Michael Mackenzie write that this is unprecedented…. James Hamilton writes that it’s hard to attribute it to changing perceptions about the Fed…

We are very far away from anything I would like to call “social science” or even “forecasting” here–“haruspicy”, or perhaps “plastromancy” captures it better…

With that caveat, I have been struck for a while by what we see when we break up the 10-Year TIPS rate into its 5-Year TIPS and its 6-10-Year Forward TIPS components:

If you read this graph as showing the expectations of Ms Market over the next five and the subsequent five years, we get the following for the market’s ideas about the real interest rate:

1) Over 2003 to mid-2005, a constant 0-5 year rate and a 6-10 year expected rate+term premium that falls from 3%/year to 2.3%/year, presumably as Ms Market adjusts to the idea that there might actually be a global savings glut and hence a lower Wicksellian real natural interest rate in the long run:

2) Over mid-2005 to 2006, a rise in the 0-5 year rate to 2.3%/year or so and a 6-10 year expected rate+term premium that remains steady, presumably as Ms Market now expects more of a full-employment economy and a stronger demand for funds to finance real investment than had seemed likely before mid-2005:

3) Over 2007 to mid-2010, a constant 6-10 year expected rate+term premium of 2.3%/year (save for the height of the financial crisis itself, with the yield spike from fears of TIP illiquidity). Ms Market appears confident that whatever happens, by 6-10 years out the ocean will be calm and flat again at the global savings glut Wicksellian real natural rate of 2.3%/year. And over 2007 to 2010 we have (a) the steep fall in the 5-Year TIPS yield as Ms Market expects aggressive monetary policy over a five-year horizon, (b) the step rise in the yield as Ms Market thinks something very bad might and then is happening to TIPS liquidity, (c) the return to normal slow-recovery views of the 5-Year TIPS yield like these previously seen over 2003 to mid-2005, and (d) the further collapse of the 5-Year TIPS yield to zero as Ms Market recognizes that this is not your normal slow recovery, that there are few if any of Tim Geithner’s “green shoots”, and that it will be a long slog:

4) Over mid-2010 to mid-2013, the collapse in the 5-Yr TIPS yield to -1.4%/year and the collapse in the 6-10 year expected rate+term premium to 0%/year as Ms Market recognizes that this time–with QE∞, permanent underemployment, and secular stagnation–really is different:

4) In 2013, taper-talk: Bernanke’s announcements interpreted as signaling that the FOMC thinks the question is not whether but when to normalize, and the consequent rapid semi-normalization of the 6-10 year expected rate+term premium and rapid rise of the 5-Year TIPS to near 0%/year:

5) Since late 2013, a belief by Ms Market that the Federal Reserve is still planning to start serious normalization–but with a start date that seems to be pushed out an extra week for every week that passes–coupled with a dawning recognition that we are unlikely to be anywhere close to normal in years 6-10, hence the late-2013 belief that you should bet on the economy being at a semi-normal Wicksellian real natural interest rate in 2020 was probably wrong:

Is there actually an intelligent entity–some kind of distributed anthology intelligence suffering from some sort of aphasia–that we call Ms Market that actually has expectations and whose expectations we can read off of bond yields? And if there is such an entity, is there any reason we should pay any attention to her expectations either as guides to some central tendency of investor sentiment or as forecasts that are in their own right worth incorporating into our own information sets, and hence into our own forecasts? Who knows? I don’t.

What I do know is that if we are willing to divine some market-sentiment-macro-expectations factor out of TIPS and other yields, the past eight months or so have seen Ms Market become much more pessimistic about the state of the real economy and thus of real interest rates six to ten years hence.

The one thing casting doubt on this interpretation is the failure of the 6-10 year inflation break-even to decline. It has been hanging out there at 2.5%/year (with notably rare exceptions) since 2004:

If I were an inflation hawk I would say that right now Ms Market expects us to get the economy in five years to a place where it is then doing its normal thing that it does when we target 2%/year inflation–and that is a powerful sign that our current taper policy is on the right track. But when I look at the sub-zero 5-Year TIP and at the 0.6%/year 6-10 Year TIP I read that as Ms Market decoupling its inflation expectations from its real growth and real interest rate expectations, and not in a good way.

The new bond market conundrum is thus yet another reason for the sun to appear dark in my eyes…