What the U.S. Long Bond Market Is Telling Us

by Jérémie Cohen-Setton on 22nd November 2009

What’s at stake: Short-term interest rates in the US turned negative on Thursday. That means that investors are piling into Treasuries to such an extent that they’re now willing to effectively pay the government for the benefit of owning them. But it’s not clear how long we can expect this to go on, especially if, as the Obama administration seems to worry, the demand for long-term government debt is driven by a “carry trade” where financial players borrow cheap money short-term, and use it to buy long-term bonds. Could further increases in deficit financing cause long term rates to spike?

Paul Krugman says that we should be worried if long-term rates looked unreasonably low given the fundamentals. But they don’t as we face the prospect of a prolonged period of near-zero short-term rates which should mean substantially lower long rates. Now what about the possibility of a squeeze, in which rising rates produce a vicious circle of collapsing balance sheets among the carry traders, higher rates, and so on? But if it does happen, it’s a financial system problem — not a deficit problem. And the remedy should be financial, not fiscal. Have the Fed buy more long-term debt; or let the government issue more short-term debt. It would basically be saying not that the government is borrowing too much, but that the people conveying funds from savers, who want short-term assets, to the government, which borrows long, are undercapitalized. The point is that it’s crazy to let the rescue of the economy be held hostage to what is, if it’s an issue at all, a technical matter of maturity mismatch.

Rajiv Sethi highlights what Krugman seems to be advocating: if long term rates should start to rise, the Treasury should finance the deficit by issuing more short-term (and less long-term) debt, thereby flattening the yield curve and holding long term rates low. This would prevent capital losses for carry traders. In effect, Krugman is arguing that the Treasury should itself act like a carry trader: rolling over short term debt to finance a long-term structural deficit. What is currently preventing the Treasury from borrowing at much more attractive short rates to finance the deficit? Is it is a fear of driving up short rates? And if so, won't the same concerns be in place if long term rates start to rise?

Angry Bear says what is currently preventing the Treasury from borrowing short is strict taboos at the treasury against this sort of thing. The origin of this taboo is that fiscal honesty requires the Treasury to act like a private firm. A private firm that issued a huge amount of short term debt to finance medium and long term liabilities is vulnerable to bankruptcy. The firm has to roll over its short term debt. A prophecy that it will fail to do so will be self fulfilling. What’s more the Treasury has to constantly fight politicians who want to cheat and understate the deficit. This temptation can only be resisted by strong taboos and bogus arguments based on wildly overstating the risk the Treasury will go bankrupt.

Brad DeLong says that he is not sure not sure Krugman is correct when he says that the possible underlying problem is merely a technical matter of maturity mismatch. The long Treasury market is thinner than many people think: it is not completely implausible to argue that it is giving us the wrong read on what market expectations really are because long Treasuries right now are held by (a) price-insensitive actors like the PBoC and (b) highly-leveraged risk lovers borrowing at close to zero and collecting coupons as they try to pick up nickels in front of the steamroller. Bear in mind that this whole story requires that the demand curve slope the wrong way for a while – that if the prices for Treasury bonds fall carry traders lose their shirts and exit the market, and so a small fall in Treasury bond prices turns into a crash until someone else steps in to hold the stock.

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