January 17, 2002
From the desk of Mindles H. Dreck:Bonds, bonds, those musical notes
I have one simple thing to add to Chris Pellerito's comment on Bonds and the deficit (Daschlenomics). Chris says:
The US does not finance much of its debt with 30 year bonds. In fact, the duration of the national debt (a fancy way of saying the average time to maturity) is just under 5 years.
Absolutely right. The Treasury actually stopped issuing 30 year bonds in November of last year. Both the fact and the way that they did it were highly controversial.
A few points of information (OK, I lied, several not-so-simple things):
1)30-year conventional mortgages are priced off the 10 year Treasury Note (it has to do with the expected duration of a mortgage - you probably don't want to go there if you don't know already). So if you want to get a sense of how mortgages fluctuate, look at the ten year Treasury Note.
2) Chris says "lower yields mean that it would cost more to retire long-term debt from bondholder' hands." True, but at any point in time, the price to retire the bond is higher by the present value of the amount by which the coupon exceeds the current market rate for an equivalent bond. So you either pay the extra amount out in coupon over time, or you pay it now and lower your coupon payments going forward. So the decision to run old, high-coupon debt out vs. retire it is neutral in present-value terms (unless you know something about interest rates the market doesn't know)
3) Chris says there is "no historical relationship between federal borrowing and mortgage rates." This is true only in a narrow sense - there have been many factors affecting mortgage rates (or, if you like, the 10-year Note) other than the deficit, but government borrowing is important. If the government went out and borrowed an amount equivalent to 100% of GDP (i.e. a huge amount), yields across the curve would jump because a) the market would expect dramatically higher inflation, which erodes the price of bonds and b) price has to react to the increased supply of debt, unless the demand for Treasury debt is completely elastic, which it clearly is not. The price of the 10-Year would likely decrease (the rate would increase) and the mortgage market would react. So, as much as I hate to affirm any part of Daschle's ill-informed diatribe, There is truth to the statement that increased federal debt can increase mortgage rates.
I think it would be more accurate to say that within the amounts of deficit and surplus we are talking about, the effect on interest rates would be negligible. The U.S. is in very strong fiscal shape, and borrows substantially less than our OECD brethren. Expected inflation can remain low at borrowing and spending levels that keep us in this very strong relative position. If we woke up tomorrow with Spain or Italy's balance sheet and future fiscal profile, interest rates would go up. For sure.
Here is a quick link on why interest rates change. One of the very important statements here is -
People who study interest rates find that it is as difficult to forecast future interest rates as it is the weather.
I'll take that one step further. Professionals in general have predicted interest rates with far less success than your local weather man. Which is another reason why it's funnny that Daschle is trying to reduce it to a one-factor model based on relatively modest changes in government borrowing.
I love the bond market myself, but not for the reasons discussed here. For some reason I don't think I won any converts with this post.
I made some slight edits to avoid misinterpretation
Posted by Mindles H. Dreck at January 17, 2002 10:27 PM | Technorati inbound linksYour analogy has two flaws. First, it is impossible for the government to "borrow the GNP." GNP is a measure of wealth created, not funds available. While there is no firm answer as to how much cash is floating about the world, it seems safe to say that it isn't $12 trillion. Second, borrowing in the market doesn't cause inflation. Borrowing in the market is an exchange in the form of assets. Inflation is caused when the Federal Reserve monetizes Government debt. And monetizing the debt, as pointed out above, is impossible. Sort of like paying everyone the "average" salary.
Posted by: Robert W (Bob) Smith on January 18, 2002 01:57 PMYour working too hard at parsing that post and you've misread it as a result -
The market judges credit quality of sovereign debt by many measures, including the issuer's borrowing as a percent of its GDP. Of course you can't "borrow the GDP" (please), but you can borrow an amount equivalent to a percentage of GDP. "100% of GDP" is used above as an example of a ridiculous and alarming amount of new borrowing, as you point out in your comment.
Second, the point is that bond markets view excess government deficits (implied by ridiculous levels of incremental borrowing) as a) reducing credit quality and b)yes, potentially inflationary. Mostly in the extreme because at some point the government has to print money to pay it back. The pure increase in the market supply of debt will force rates up long before concerns about the fiscal health of the U.S. come into question.
You would be right to point out that it depends what the government does with the cash. The unstated assumption above is that if the government issues a bunch of debt, they are intending to spend it and thus put it back into circulation.
Anyway, this is a bit of a "how many bonds fit on the head of a pin" discussion.
Posted by: Andreas on January 18, 2002 03:54 PMaddendum, from the link in the post:
Depending on how much money the citizens of that country or that province save out of their own incomes, the borrowing government must sell its obligations to foreigners. By doing so, the government makes itself vulnerable to the shifting and often volatile sentiment of the international capital markets. If they have a sufficiently large external debt in relation to their GDP (as an indicator of their current and future capacity to repay), speculators might attack their currency or their country's bond markets forcing interest rates higher and causing the value of their economy to degrade in international terms.Posted by: Andreas on January 19, 2002 03:10 PM
Ben asks:
Um, I'm curious about why mortgages are priced of 10 year bonds. Please feel free to tell us...
The important term to understand is "Duration". The duration of a bond is a measure of it's price sensitivity to interest rate changes. Here's a formal definition and here's an article about duration. Duration is calculated using the present value of all the bond's cash flows (coupon and maturity). A 30-year bond might have around a twenty-five year duration, because you get some of the return earlier in the form of coupon. The duration is shorter if the coupon rate is higher. A 30-year zero coupon bond has a duration of 30 years.
Since very few conventional mortgages remain on the books to the full 30 year term (they are typically "prepaid" when the borrower moves or refinances), their expected duration is lower than their duration if carried to term. The expected duration has been calculated to be similar to that of a ten-year Treasury note, so that is conventionally used to price mortgages. The price is often expressed as a "spread", or the amount by which the mortgage rate exceeds the 10-year note yield.
Posted by: Andreas on January 19, 2002 03:40 PMComments are Closed.