When you buy a Burberry bikini, what you are buying is not a tartan bikini but a promise of exclusivity

From Worthwhile Canadian Inititiative:

"Good News! Interest rates rise.

This Bloomberg story reports the Fed saying that rising bond yields are a good sign. They don't precisely say that monetary easing is what caused the rise in interest rates; they are perhaps too modest to claim credit? But I will say it for them: by buying bonds, and easing monetary policy, the Fed has caused the price of bonds to fall, and interest rates to rise. Yep, an increase in demand for bonds causes the price to fall.

How does an increase in demand for something cause the price to fall? This could only happen if the increase in demand by one buyer caused other buyers to reduce their demand.

I can think of examples where this might happen. I remember a recent case where an "Essex girl" appeared on a British reality TV show wearing a Burberry bikini, and thereby ruined the Burberry brand image. This reduced demand for Burberry from everyone else.

Why are central banks buying bonds like an Essex girl buying a Burberry bikini? Isn't their money as good as anyone else's?

Well, no, it isn't. A central bank's money is actually better than anyone else's. That can't be the problem.

This is the problem. When you buy a Burberry bikini, what you are buying is not a tartan bikini but a promise of exclusivity. When you buy a bond, what you are buying is a promise of money in the future, and the value of that future money depends on its exclusivity. When a central bank buys a bond, and thereby increases the stock of money, it is doing something that other buyers of bonds don't do. The money will be worth less in future, and so the bond is worth less too. When Essex girl buys a Burberry bikini she lowers the fundamental value of Burberry bikinis. When the central bank buys a bond, with new money, it lowers the fundamental value of the bond.

Try telling that story without mentioning the supply of money, you Neo-Wicksellians!

This is the same argument I have been making in the past. It's not so much "I told you this would happen"; it's "I told you this ought to happen". Low nominal interest rates can be seen as a sign of tight money as much as easy money.

Quantitative Easing, like any policy to increase Aggregate Demand, is strongly reinforced if it can create the expectation it will work, both by increasing expected inflation, and by increasing expected output growth. And this makes nominal interest rates a poor choice as a monetary policy control instrument. If the central banks wants to make monetary policy easier, it tries to lower interest rates, by buying bonds. But if it is seen as successful in making monetary policy easier, and increasing AD, it will be raising nominal interest rates. This makes it very hard for the market to interpret changes in interest rates. And this makes it very hard for the central bank to generate that cumulative self-reinforcing confidence that the policy is working. "Look, I'm pushing the lever down, and it must be working, because the lever is moving up!"

That confusion in interpreting the rise in interest rates is reflected in the last part of the Bloomberg story:

The situation poses a “dilemma” for the Fed, because if the rise in yields reflects “erroneous market views” about the economy, it will hold back growth, said former Fed Governor Lyle Gramley.

“The Fed is probably scratching its head at the moment and will wait and not react until the smoke clears,” said Gramley, who is now a senior economic adviser with New York-based Soleil Securities Corp.

There are the Fed's "market views", the bond market's "market views", and firms' and households' "market views" when they make consumption and investment decisions. The danger is if the bond market thinks the policy is working, and expects higher inflation and real output growth, but firms and households don't. The bond market raises nominal interest rates, because it sees the IS curve as having shifted as a function of the nominal interest rate. But if households and firms stay pessimistic, and don't share the bond market's views, consumption and investment will fall.

Posted by Nick Rowe"

Me:

I thought that the plan of QE was to keep short term interest rates low, giving investors an incentive to invest in other higher yielding pursuits now, and have longer term interest rates rise, showing that deflation is being defeated and signaling a recovery in the future when rates will have to go up. In other words, QE attacks the Fear and Aversion to risk with short term incentives and longer term confidence. As far as I can tell, it's working pretty well, if slowly. Posted by: Don the libertarian Democrat

rising bond yields

TO BE NOTED: From the FT:

Video12:30AM

Markets fear rising bond yields

Worrying trend overshadows stress tests, says John Authers

"The gap between bond and equity yields is becoming a critical issue in financial markets.": Is Anything Not Critical?

Here's an interesting post on the FT by Tony Jackson:

"The gap between bond and equity yields is becoming a critical issue in financial markets.

For half a century, equities have consistently yielded less than bonds. But the reverse is now starkly true in both the US and UK. Something is badly wrong."

Yields: For The Last 50 Years

Bonds: Higher

Stocks: Lower

This has changed? Can we tell yet if it's a positive or negative change?

"The obvious place to look for clues is Japan, which has had a reverse yield gap on and off for years. So do investors think the Japanese disease of deflation and economic contraction is coming to the west?"

Yields: Today

Stocks: Higher

Bonds: Lower

This means:

Economic Downturn

Deflation

In Japan, this meant an economic downturn and deflation. Does it mean that here?

"The short answer is probably yes. But, to clarify the logic, we should first consider the relationship between bond and equity yields more closely."

Yes, and he'll tell us why.

"Until 1959, the norm was for equities to yield more than bonds in both the UK and US. This was a simple expression of what is now called the equity risk premium."

Previous to the last 50 years, we had the following:

Yields: More Than 50 Years Ago

Stocks: Higher

Bonds: Lower

Reason:

Equity Risk Premium

This sounds like it means that stocks involve more risk than bonds. Let's see. Words can be awfully deceptive at times.

"Just as in a horse race, where the odds are better on an outsider than on the favourite, it seemed obvious that risky equities should promise a higher return than safe bonds. But, from 1959 onwards – until today – the formula reversed. Why was that?"

A gambling reference. How interesting. You'll win more if the underdog wins in a horse race. In the horse race between stocks and bonds, stocks were considered the underdog. The underlying theme is that you expect a higher return for more risk.

"Financial theory – which, not coincidentally, had its origins in the 1950s – has an answer to that. As Professor Paul Marsh of the London Business School explains, it allows us to state that the yield gap equals the expected risk premium on equities minus the expected growth in dividends."

You figure out the risk premium for a stock, and then subtract it from the dividend yield of a stock.

"Before the reader’s eyes glaze, let me hastily say this expresses a fairly simple concept. To arrive at the equity yield, investors notionally add a risk premium to the bond yield. But they then adjust for the fact that equity dividends grow in real terms and also tend to rise with inflation, whereas bond dividends do neither."

The yield of a stock dividend =

1) The Bond Yield +
2) Some Extra Money To Compensate For The Fact That Stocks Are Riskier +
3) Since Stock Dividends Can Go Up ( Or go down ) , Whereas Bond Yields Are Often Fixed, You Have To Fiddle With The Figures A Bit. In this scenario, it sounds like stocks can be less risky over time, since they can figure in inflation, for example.

"It follows that inflation and growth are both crucial in determining whether the yield gap is positive or negative. The higher each of them is, the more equity yields will tend to fall below bond yields."

On 3, the higher inflation and growth is, the less risky stocks are as compared to bonds, so the yield of stocks will fall in relation to bonds.

"The Japanese example supports this.
Peter Eadon-Clarke of Macquarie has a chart comparing the Japanese yield gap with nominal GDP growth over the past decade. Broadly speaking, when nominal GDP is negative, the yield gap tends to be too."

3 happened in Japan, only in reverse. As GDP went down, stocks got more risky.

"The GDP figure here may be taken as a rough proxy for dividend growth. And the essential point is that it is nominal, thus including inflation. Generally, for nominal GDP to shrink, both inflation and growth must be negative. Japan is the one country to have displayed that malign combination so far."

In economics, nominal value refers to any price or value expressed in money of the day, as opposed to real value, which adjusts for the effect of inflation.

GDP = Dividends : in this example

"I should add that the historic record is rather less tidy. Prof Marsh has data* showing that both dividend growth and inflation were higher in the second half of the last century than in the first."

What about the first 50 years? Why did it change 50 years ago?

"But I calculate that, in the five years to 1959, US inflation and GDP growth were both higher than in the five years following. So why the crossover should have happened just then remains problematic.'

"Problematic" means "Unexplained". One question is whether investors came to simply value dividends less, or were there changes in the tax laws, etc. ?

"In addition, a crucial part of Prof Marsh’s equation is the equity risk premium. But, as he puts it, the premium is unobservable – that is, it can be measured only in retrospect, not at the time."

Oh dear. That's a serious problem for looking forward.

"All that suggests that, when we come to the present situation, we should proceed with due caution. That said, what do we think is going on now?"

No one knows exactly what's going on, but:
1) I need to post a column, and this is pretty interesting.
2) Since no one knows exactly what's going on, there's room for me to speculate without fear of being clearly refuted. Unless, of course, I use fallacious reasoning, misread graphs, etc.

"In essence, the steep fall in Treasury bond yields across the developed world does indeed suggest strongly that investors fear deflation while the steep rise in equity yields suggests they fear a sustained collapse in dividends. And they are presumably also pricing in a higher risk premium for equities. So all the parts of the equation are heading the same way."

Before, wasn't it a kind of inverse ratio?

"That said, the reality is slightly more complex. Today’s low bond yields represent a tension between opposing forces. On the one hand, investors crave security. On the other, an enormous amount of new bond issuance is likely on both sides of the Atlantic."

The tension sounds like supply and demand.

"And, with another part of their minds, investors do not regard bonds as all that safe. The cost of insuring UK government bonds against default has risen from eight basis points in February to 110 basis points today – still quite a modest level but not reassuring."

It reminds me of the song line, "Trying To Make It Real, Compared To What?".

"In fact, bond yields could prove the vulnerable part of the equation. In the bubble years, risk was ludicrously underpriced. Quite reasonably, we should now expect it to become overpriced by a similar amount."

That's what I basically expect, except that it isn't an exact equation, although "similar" might be fine.

"When that eventually corrects itself, bond yields should rise. Equity yields might also fall – to the extent that investors recover their risk appetite. And indeed, fears of deflation might prove unfounded, as might the prospect of an extreme collapse in dividends.

But not just yet, I think. In the meantime, the old-style pre-1959 yield gap could become part of the landscape."

Let's see: 3 mights, 1 should, 1 to the extent, 1 not just, 1 think, 1 could. Thanks for going out so far on a limb. We'll keep track of all of your hedged bets, to use a gambling phrase.

This isn't the first post I've read about this. It is, however, among the clearer and more interesting. In fairness to Tony Jackson, I've laid off this topic precisely because they have to include a lot of speculation.