Response to reader inquiry regarding chart signals on yield differentials

Hi Mark,

Thank you for your email regarding my “Special Delivery” article

I am no expert in treasury bonds so I can’t really guide you beyond a very high level view. But here’s what I know.

About 25 ago I was approached by a  stockbroker who specialised in Treasury Bonds who asked me if I could apply technical analysis to interest rate movements. They wanted to publish a weekly advisory letter to their institutional clients. Up  until that time (in South Africa, where I lived at that time) no one had done that, so I guess you could say that I am a pioneer in that field. J  I must have done something right because, within a year, I was voted number two in the country in a nationwide poll of those institutions.J

Before that time (if I’m not mistaken) the way bonds were valued was based on a concept called yield to maturity.

Then, around that time a new method evolved called the “Black Scholes” method which, if I’m not mistaken, is still used today. You can look up that subject on the internet or buy a book on it.

But to understand the underlying principles it is critically important that you have a crystal clear understanding of the following:

In very simple terms, “inflation” is built into the western world’s monetary system. The definition of inflation is an increase in the money supply. The money supply “inflates” when he central bank puts more money into circulation.

In theory, (going back to 1913), if the money supply is inflated by (say) 3% p.a. and the population of a country increases by (say) 1% p.a. and there are no improvements in efficiency, then prices will rise by around 2% p.a.  because there will be (3% – 1%) more money per capita chasing the same amount of goods and services (per capita).

In theory, if efficiency increases by (say) 2% p.a. (ie people learn ways of producing 2% more with the same resources) then prices will not rise.

In practice, from memory, up until the late 1900s, the Federal Reserve Bank has inflated the money supply by around 6% p.a. and there was some price inflation. That’s why the purchasing power of the dollar has fallen.

Conversely, because there’s price inflation, a dollar today is worth more than it will be in the future.

Let’s say, for example, that money supply rises 6% p.a. and population rises 1% p.a. and there is no improvement in efficiency. This implies (in round numbers) that prices will rise by 5% p.a..

This also means that the value of the dollar will fall by 5% p.a. because it will buy less.

Below is a table which shows what will happen to a dollar over 20 years if it loses 5% p.a.

In 20 years time a dollar in today’s market  will only be worth 38 cents. It will have lost 62% of its value

So we have something called the “time value” of money. Anyone who wants to borrow money will need to pay a premium to compensate for the loss of value of the dollars borrowed because of inflation.

Then, over and above that, the lender wants to be compensated for lending the money. He wants to earn a profit too. That profit is the interest rate over and above the inflation rate and it is dictated by the market place by the forces of demand for and supply of credit.

So, over the years, depending on whether the economy is expanding or contracting the “real” interest rate (the difference between the coupon rate and inflation) rises or falls.

Now, if inflation rises to say, 6%, look what happens: The dollar falls to 31 cents

But there is something even more interesting that emerges. Look at year 10 (for example) in both tables. In table # 1, the value is 63 cents and in table #2 the value is 61 cents.

Whilst the  difference in 20 years time is 7 cents,  the difference in 10 years time is only 2 cents. So a concept called “capital risk” emerges.

There is less “risk” to the lender that he will make capital losses if he prices his premium at a slightly lower level for a shorter dated loan. So this is essentially why a shorter dated Treasury Bond (a certificate of an IOU by the government to its lender) will have a lower “coupon” than a longer dated Treasury Bond.

The picture is complicated by the fact that in recent years three things have happened:

1.       The Federal Reserve has been printing more money (Money inflation has been increasing by more than 6% p.a.)

2.       There has been a shift in the USA from an industrial economy to a service economy. (Efficiency has been growing faster than usual)

3.       Industrial activity has shifted to countries with a lower wage base

Efficiency is defined loosely as achieving a greater output with the same input. In a service based economy the world of IT has allowed efficiencies to grow strongly. Further, because manufacturing has moved from high wage base countries to low wage base countries, prices of some goods have actually fallen.  The world economy has gone through a “sweet spot” as efficiencies skyrocketed for a brief period. That has now passed.  We will never see that sweet spot again. Ever. And the sweet spot allowed some fortunes to be made in the field of investment – by people who are no smarter than you or me. They just happened to be in the right place at the right time.

The above three developments have complicated the relationship between inflation of money supply and inflation of prices. No one really understands that relationship well enough to be able to model it and any “opinions” regarding inflation or deflation are just that – they are someone’s opinion – which is why the charts are becoming so very important in monitoring the bond markets. The charts reflect the “balance of opinion”.

Now let’s get back to the main subject and to your original question:

When interest rates rise, the face value of a Treasury Bond should fall to compensate. Here’s an example:

If the government wants to borrow $100 and the prevailing interest rate is (say) 9% then the lender  will charge the government $9. The yield on a government bond is basically the price of the money that the government pays for the privilege of borrowing that money.

(As an aside there has been a lot of “wild” discussion about the Fed’s ability to create money out of thin air. In theory it has this ability. In practice there are limitations to this ability. The US does not exist in a vacuum. It only represents 25% of “the market”. Bernanke cannot just do what he wants when he wants. If you have ever seen Alfred Hitchcock’s movie “The Birds” then you will know what I am talking about. When the flock of peacefully twittering birds turns against you it can rip you apart. Bernanke is not superman. The USA is not invincible.)

If interest rates rise to 10% and you are only paying $9, then how much can you sell the bond to a third party?

The answer is $9/10% = $90. If the buyer pays $90 then the governments payment of $9 interest will yield the new owner 10%.

Conversely, if interest rates fall, the prices of Treasury Bonds rise.

It’s not as simple as that and relationships are not linear  which is (I understand) what Black Scholes is all about.

If you understand everything I have written above then you will understand why it is so very noteworthy  that the yields on shorter date Treasury Bonds are rising faster than the yields on longer date Treasury Bonds.

In a world of inflation, because there is a “risk” gap between the yield on a long bond and a short dated bond, the gap should be growing because the risk of capital losses through loss of purchasing power  is growing.

When the gap narrows – everything else remaining equal – if the risk of inflation is perceived to be FALLING then the gap between long dated yields and short dated yields will be CONTRACTING – which is what the charts are showing is happening.

But right now this is all about perceptions. Falling inflation is what the bond market “fears” might happen. The problem only becomes a real problem when we have what is called a yield inversion. That is when the short dated yields are higher than the long dated yields.

Typically, this does not precede deflation because the definition of deflation is “a decrease in the money supply” and the Fed has NEVER (in all its history dating back to 1913) pulled money off the table. It ALWAYS prints more.

So, arguably, the main theoretical reason an inverted yield curve manifests is that lenders are worried about debt default. They are worried about the risk of losing their capital through default as opposed to loss of purchasing power. But its more complicated than that.

If the US government is the ultimate borrower this risk of default hasn’t really been a risk (up to now) so an inverted yield curve has typically been a warning sign of a coming recession. In the early period of a  recession, businesses get stuck with high levels of inventories and what they typically do is cut prices to move volumes. Price wars erupt as businesses fight for market share and as they fight to convert slow moving inventories into cash and what happens is that, for a short period, prices actually do fall. We do have price deflation which may or may not be related to money supply deflation

Now, the reality is that in a serious recession we do sometimes experience Deflation (remember the definition of deflation is a contraction in the money supply). This happens not because the Fed takes money off the table, but because money disappears at the margins when losses are incurred.

Definition: In economics, the money supply or money stock, is the total amount of money available in an economy at a particular point in time.^[1] There are several ways to define “money,” but standard measures usually include currency in circulation and demand deposits (depositors’ easily-accessed assets on the books of financial institutions).^[2][3] (source:  http://en.wikipedia.org/wiki/Money_supply)

The way “deflation” might happen is if demand deposits contract because the depositors withdraw money to cover losses they incur in a recession.

Mark, one reason I am going into all this “theory” is that I have received more negative criticism in the past few weeks in relation to my recently expressed views on deflation than in the last eight or so years in combination.   None of this is “hurting” me because when you know what you are talking about you have a fairly high degree of confidence that can withstand such criticism and, of course, if you are (I am) wrong then it’s not particularly damaging to your ego. You adjust your thinking, you learn something and you move on. Being wrong is more damaging to one’s ego than one’s reputation. It takes less energy to say “I’m sorry, I was wrong” than to try to justify an unjustifiable situation. That latter kind of behaviour does tend to adversely impact on one’s reputation.

What is becoming apparent to me is that those who are criticising me are coming from a base of inadequate knowledge. They don’t fully understand why a contracting gap between the short and long dated yield curves is so  very important. It is important because it is a sign that the capital markets are tightening. Lenders are becoming nervous about the “risk premium” that they need to charge in an environment of possible money supply deflation.  This is showing up in the shorter dated Treasuries because in the long term we ALWAYS have inflation. Inflation will come back. But in the short term, if we have deflation, the perception of risk shifts – from the possibility of losing some purchasing power to the possibility of losing all your capital.

Please bear in mind that I have dashed this article off in around 30 minutes and it will have some inaccuracies and imperfections. Try to ignore those and focus on the principles. I am not an economist and neither am I a professional adviser in the financial markets.  I am just an ordinary bloke who happens to have a high level of interest in the subject. I am semi retired. I live very modestly in a geographical paradise and I write factional novels because I can. J

A it happens, I am targeting to complete the manuscript of The Last Finesse by April 2011. If you or your friends or associates would like to buy a copy, please email me at[email protected] and let me know if you would prefer a hard copy or an e-book. I will contact you again when the book is available.

Hope this helps.

Kind Regards,

Brian Bloom

Author, Beyond Neanderthal

Author, The Last Finesse

www.beyondneanderthal.com