Morning Must-Read: Cardiff Garcia: The Maddening Bond-Market Conundrum-Redux Conundrum

…Moving to look at a different part of the mirror only distorts a different part of the reflection. And given that this is his only mirror, how does he know which parts are distorted and which are accurate in the first place? To witness such slapstick nonsense is like trying to observe the relationship between the economy and the yield curve….

The supply dynamics of advanced-economy sovereign debt, with net issuance available to the public set to turn sharply negative this year and next, are mostly fixed in the near-term. (The demand dynamics are more complicated, dependent as they are on macroeconomic outcomes.) And these dynamics suggest that longer-dated US Treasury yields will be under pressure yet again because of foreign demand, with much of the cause assignable to the combination of aggregate fiscal austerity and current account surpluses in Europe, in addition to the ECB’s quantitative easing program, which is more aggressive than had been expected earlier this year. Once the Fed begins to hike the policy rate later this year, there is a chance that longer yields will not follow them higher. What would this mean? Does it foreshadow a repeat of the conditions that prevailed in the mid-2000s, when Alan Greenspan labeled the failure of long rates to attend his own tightening of policy a ‘conundrum’?Unfortunately, an effort to understand the relevance of a new bond market conundrum risks a lapse into ‘haruspicy, or perhaps plastromancy,’ as Brad DeLong writes. The relevant sample size is too small….

If a new conundrum becomes reality:

(1) The Fed responds to a new conundrum by loosening policy, promising to delay further rate hikes and lowering its forecasted path for policy rates. Simultaneously, to target the curve more directly, the Fed might also sell some of its longer-dated holdings — and, if it would rather not shrink its balance sheet too much, the Fed could also buy short-maturity debt in a kind of reverse Operation Twist. What would happen?

One possibility is that inflation expectations would climb, with the market interpreting the move as a willingness by the Fed to tolerate a higher path of economic growth and inflation than was previously understood. The curve would thus steepen, and the steepening would be reinforced by the Fed’s direct involvement in the Treasury market.

Another possibility is that the market would interpret the move as a renewed commitment by the Fed to keep rates low for longer than had been expected. If long-term rates do indeed reflect the expected path of short-term rates, then these long-term rates could fall in tandem with the Fed’s action. The curve would actually flatten even more, perhaps enough even to offset the Fed’s direct involvement in the Treasury market.

(2) The Fed responds to a new conundrum by tightening policy, following Dudley’s prescription and raising policy rates more quickly. To target the curve more directly, the Fed might also start selling down its longer-dated holdings. What would happen?

One possibility is that inflation expectations would fall, with the market interpreting the move as a willingness by the Fed not to tolerate the higher path of economic growth and inflation that lower long-term rates might lead to. The curve would actually flatten even more, perhaps enough even to offset the Fed’s direct involvement in the Treasury market.

Another possibility is that the market would interpret the move as a new commitment by the Fed to follow a higher path for its policy rates. If long-term rates do indeed reflect the expected path of short-term rates, then these long-term rates could rise in tandem with the Fed’s action. The curve would thus steepen, and the steepening would be reinforced by the Fed’s direct involvement in the Treasury market.

You see what I did there….

Have a nice day.