Stable Money Implies an Inverted Yield Curve

Suppose we had stable money. It’s then obvious that long-term savers would prefer long-bonds to rolling over short bonds. If held to maturity, the long-bond guarantees a known rate of return and payout at the time it is bought while the rolling of short-term bonds exposes you to risk. Thus, in a regime of stable money, long-term savers should prefer long-bonds and the yield curve should normally be inverted. That’s the essence of an excellent post by John Cochrane:

If inflation is steady, long-term bonds are a safer way to save money for the long run. If you roll over short-term bonds, then you do better when interest rates rise, and do worse when interest rates fall, adding risk to your eventual wealth. The long-term bond has more mark-to-market gains and losses, but you don’t care about that. You care about the long term payout, which is less risky. (Throw out the statements and stop worrying.) So, in an environment with varying real rates and steady inflation, we expect long rates to be less than short rates, because short rates have to compensate investors for extra risk.

If, by contrast, inflation is volatile and real rates are steady, then long-term bonds are riskier. When inflation goes up, the short term rate will go up too, and preserve the real value of the investment, and vice versa. The long-term bond just suffers the cumulative inflation uncertainty. In that environment we expect a rising yield curve, to compensate long bond holders for the risk of inflation.

So, another possible reason for the emergence of a downward sloping yield curve is that the 1970s and early 1980s were a period of large inflation volatility. Now we are in a period of much less inflation volatility, so most interest rate variation is variation in real rates. Markets are figuring that out.

Most of the late 19th century had an inverted yield curve. UK perpetuities were the “safe asset,” and short term lending was risky. It also lived under the gold standard which gave very long-run price stability.

Comments

I think it is clear our regime is collapsing around us. I told the guys at the bar while we were watching the game a couple days ago, I don't trust our leaders anymore. They are all hat and not cattle. The beef is nowhere to be found.

I think you mean, "All Hat and No Brains."

Imagine if you will a world where inverted (and flat, for that matter) yield curves are harbingers of depression and deflation.

Central bank manipulations cause near-zero and negative interest rates. At its maximum, the US Fed's total assets (TA) were $4.5 trillion, now $3.8 trillion; before the financial catastrophe Fed TA were $.9 trillion. At the heights, the Fed owned 24% of US public debt and 17% (indirectly) of US home loans.

FOMC actions have been boons for equities investors and bond holders (bond bull market since 1981) and curses for savers. They are price controls.

Re: The post. It ignores many bond pricing factors in addition to inflation risk.

I suppose you're buying gold b/c you don't trust your Fed leaders anymore. China's CB that recently purchased 16 tons of Au. Me, too.

"I think you mean, 'All Hat and No Brains.'"
That too.

"I suppose you're buying gold b/c you don't trust your Fed leaders anymore"

I have recently come to distrust our leaders. I intend to buy gold and guns to insulate myself and my family from the inevitable breaking down of our political-economic system.

Why do you think society will break down? Trump is our President, don't you know.

Whatever happened to that blackamoor you had? The Reverend Captain Doctor Field Marshall Bolsonaro is pure blood.

That is the impersonator.

we believe you buddy!
did any other young cannibals notice that canadian sociologist gladwell slipped into sophistry with his s. bland/policeman narrative!
anybody else spot bigly fact he omitted that sorta
irreversibly invalidates/fubars his narrative?

"I think you mean, 'All Hat and No Brains.'"
That too.

"I suppose you're buying gold b/c you don't trust your Fed leaders anymore"

I have recently come to distrust our leaders. I intend to buy gold and guns to insulate myself and my family from the inevitable breaking down of our political-economic system.

FOMC actions have been boons for equities investors and bond holders (bond bull market since 1981) and curses for savers. They are price controls.

Could you explain how someone can own stocks and bonds and not also be a saver?

Likewise claims of price controls that lack a coherent theory of what an uncontrolled price should look like have a serious problem IMO.

(bond bull market since 1981)

So nearly 40 years of 'price controls' huh? This is a strange type of price control where inflation goes from double digits to single digits, almost no digits. If I didn't know better I would almost think Austrians were angry that the Central Bank essentially pulled off a gold standard with fiat money....or at least pulled off most of the promises of a gold standard with fiat money.

Low interest rates caused by market efficiency: good.

Low interest rates caused by flight to safety: indication of problems.

Low interest rates cause by wanton money creation: bad.

You can look at a chart of bond yields and SEE the 40 year bull. You can look at a chart of money supply. You don't need to see the theory. It is obvious from first principles.

Nice, let me know when you find some first principles. Tossing around adjectives isn't a first principle.

How do I know when money creation is 'wanton' versus 'non-wanton'?

"Flight to safety" is bad but market efficiency good? Isn't it market efficiency to ditch an investment you discover is riskier than you thought and buy one that is less risky?

There are many examples of economies that used temporary price controls in history (WWI, WWII, the early 70's etc.). There are very few examples of economies that tried extensive price controls for decades (Cuba comes to mind). I'm at a loss to think of an example of an economy that used extensive price controls for 40 years and looks better at the end of that period than the beginning. You seem to be trying to tell us the US is just such an example hiding in plain sight for decades. Really?

By "first principles" I obviously mean the impact of money supply on interest rates. The extended bond boom has been CAUSED by loose monetary policy. There are certainly other factors that affect interest rates, but MS is the most direct, just like prices are the most direct influence of quantity demanded.

Flight to Safety itself isnt bad. It is an indicator of severe market distress somewhere else.

Wanton money creation is crystal clear to anyone who ever studied economics. Money growth that matches economic growth is good. Money growth that is used as an artificial economic boost is disastrous. Put me in sole charge of the Fed and I could wreck the economy for a decade in just a matter of weeks.

While I didnt mention price controls, the OP above did and interest rates are prices. You're deluded if you havent seen long term price controls. Minimum wage, rent control, and agricultural price floors are the most obvious. Usury laws and deposit interest rate caps are others.

The extended bond boom has been CAUSED by loose monetary policy

If inflation is falling or low, monetary policy cannot be loose. Extended loose monetary policy collapses bond values, it doesn't boost them.

"Money growth that matches economic growth is good. Money growth that is used as an artificial economic boost is disastrous."

Much like your use of 'wonton', this is an example of something that reads like it makes sense until you think about it. Say you loosen monetary policy and economic growth goes from 3% to 4% but inflation remains the same. That's good per your rule. Wait, maybe that 1% is 'artificial growth'. Wait maybe you already had 1% of artificial growth and now you have 2% is artificial growth. Good growth versus "bad" artificial growth comes down to whatever rhetorical devices your favorite pundit is using on the business channel this morning.

"You're deluded if you havent seen long term price controls. Minimum wage, rent control, and agricultural price floors..."

These are all pretty real but are a relatively minor aspect of the US economy. Over the last 40+ years many of these minor examples of price controls have declined or remained stable making them even less of an economic influence. The only example cited so far of an economy that made use of extensive price controls over the long term that come to mind would be Cuba and possibly North Korea....none of those economies exhibited any remarkable growth...artificial or not.

All hail John Cochrane!

Oops, wrong professor.

I nominate this for dumbest MR post of the year.

And, that's saying a lot.

This is the second brightest MR comment of the year.

I nominate this for dumbest MR post of the year )))))

Re: history. I recall that in the Forsyte Saga, set in the UK around 1900, the wealthy main characters had all invested in "consols," which were perpetual government bonds (aka consolidated annuities). They were first offered around 1750, and the last consols were not fully redeemed until 2015.

That's correct. They were never supposed to be redeemed (perpetuity is a long time) but apparently the issuer had sense to put in a call provision.

We have stable money. It's called a TIPS bond (Treasury Inflation-Protected Securities).

Instability often results from shocks, which by their nature are hard to predict. I will give Cochrane credit for devising creative explanations for conditions in the economy. Cochrane: "Most of the late 19th century had an inverted yield curve." True enough. The late 19th century also had a high level of inequality, just like today. And two of the worst economic depressions in history, the Panic of 1873 and the Panic of 1893. In the latter, a total of 18,000 businesses failed between 1873 and 1875. The expression back then was "Yesterday I had my long-term corporate bonds in front of me, today they are behind me".

If Milton Friedman said, "Inflation is always and everywhere a monetary phenomenon," then....shouldn't disinflation and deflation be considered monetary phenomenon also?

Seems to me major global central banks started fighting inflation back around 1980...and won the war. But they can't stop fighting. They don't even know the war is over. Or what weapons they need now.

Bitcoin has a relatively stable money supply but it inflates and deflates depending on alignment of the stars. That is to say it is not a monetary phenomenon.

Hm... You would think time preference would cause lenders to require a higher interest rate in exchange for locking up their money for longer. For the same reason, less liquid investments generally command higher interest rates. But maybe there's something special about bonds.

There's nothing special. There is a misunderstanding or rather an academic understanding of how bonds and bond investors work.

You're right, but look at both the supply and demand side. You could have a 30 year bond or you could have a 1 year bond that is redeemed and then issued again yearly for 30 years.

For the demand side, the investor favors the year to year in an inflationary environment since each year she can be 'reset' in the interest rate depending on what inflation is doing now. The 30 year bond is only sensible if it is a higher rate to justify 'locking' up her money.

In the low inflation long run environment the opposite prevails. Each year her interest rate changes adding risk while the 30 year bond gives her a defined payout during and at the end.

Yes there is a premium for locking her money up 30 years but if she is planning on locking her money up anyway (say this is part of her 401K), then that premium is going to be low and the other factors will wash it out.

Yes, and that seems to be one of the risks that is ignored or marginalized in the suggested theory.

However, that may well be a structural/institutional feature. The main consumers of these debt seem to be institutions that may have significantly greater cash flow for day-to-day (and even year-to-year) activities than any individual. When thinking about time preferences it's hard for me to see that individual time preferences and institutional time preferences will work the same.

It is an interesting insight (as was the observation about the two big crashes during the historic example offered) but exactly what it is going to mean may still be a "TBD" item.

Well it seems to me the advice they give individuals on 401K's applies to institutions. First you can/should invest in indexes rather than individual stocks or bonds. Second, stocks presumably always have a bigger return over the long run than bonds.

Why would not institutional investors simply invest in stock indexes with a bond index as a balance for risk?

This post should be labeled "speculative".

"If inflation is stable."
If the Queen had balls, she'd be King.

this was my question.

if bondholders need to be compensated for inflation risk, why would the risk that inflation changes 12 months from now be higher than the expected range of inflation for 2050?

same applies to default risk. the fiscal trajectory of US for 2020 is stable, but by 2050, who know?

That was my first thought, but it is a fallacious retort.

He is assuming stable inflation to reveal what the term structure would be in the absence of this confounding variable. This is textbook ceteris paribus.

But it is also wrong. Positive time preference, liquidity risk, opportunity costs, interest rate risk all imply higher long term rates. Add credit risk premia if it is not government guaranteed. Add option risk with embedded calls.

Steady inflation does not imply fixed interest rates.

Cochrane demonstrates a complete lack of understanding of interest rate risk and liquidity risk. And by extension, Alex does too.

Zero coupon bonds have the worst IRR profile for a given maturity, exclusive of embedded options.

Setting aside their deficient understanding of finance, the result relies on opportunity costs which they should understand very well.

This doesn’t make sense to me. Wouldn’t we expect TIPS yields to always be inverted then? But that’s not the case.

Good point.

If i have a few million dollars and want to leverage it 40 times and make a real return, not some piddling 3%, what do i need? A government bond, not short term.

yes, in the late 1800s we did have long run price stability.

But at the same time we had extreme short term volatility and at any given moment you were just as likely to see falling prices as rising prices.

So did financial markets just ignore this short run volatility?

Question: How did 100 year railroad bonds do?
Answer: Not very well

The premise of varying short term rates and steady inflation is false. If inflation was steady and perceived to be steady in the future, rates wouldn't vary much, and there wouldn't be much risk in rolling over short term bonds

I don't know if all of the comments reflect this post's opening qualifier..."Suppose we had stable money."

Some commenters are attacking it as begging the question: "Suppose no one ever defaults on debt. Then there would be no credit risk premium."

But others recognize that the initial premise is a worthwhile ceteris paribus condition. The fallacy is that stable money means there will be no interest rate risk. Stable money, in the sense of inflation, means a constant rate of inflation. But that doesnt imply stable interest rates. The price index can be held constant by increasing or decreasing money supply such that the market basket stays the same price. But this does not mean that individual items in the basket havent seen real changes. The price index is just a weighted average.

Aside from that, interest rates arent in that basket. They are determined not just by money supply but money demand as well. Even with constant or constant growth in money supply does not imply steady interest rates, long or short term.

This is the dumbest post I have read on this blog.

Suppose that some country wants to sell you a 1000-year bond. Do you really want to tie your money up for 1000 years? Will that country even exist in 1000 years? Long duration bonds demand higher interest rates to offset two very obvious risks: liquidity, and default risk. Uncertainty about inflation plays a much smaller role.

That's not really an issue.

First, the asset is sellable. You dont need to be around at maturity.

Second, discounted cashflows in the later years are practically zero, so they play no role in your investment decision.

Default risk would be based on the likelihood of default within the investment horizon, not in perpetuity. Yields would rise as country risk grows.

Your comment about liquidity risk is correct. Little difference though between 1000 year and a 30 year though.

Sure the asset is sellable but the long duration makes it incredibly volatile relative to its short duration counterpart with respect to a change in interest rates. Since investors are risk adverse the added volatility requires a lower price (higher yield).

I am not following your point about the discounted cash flows. We can consider any bond a 0-coupon bond since we can turn any coupon bond into one with the correct duration in which case of course we care about the cash flow at the end.

Finally I am only considering default risk over the lifetime of the bond. Default risk is strictly increasing with respect to time since it’s just a surviva function. More time = greater chance of default.

With respect to interest rate risk, zero coupons are the worst, ceteris paribus, because there are no cashflows until maturity.

Yes, there can be bonds with an equivalent duration to a zero, but they will have different cash flows. Duration is not the end all and be all of interest rate risk. Cash flows are. Duration is a summary measure. You're also not holding all else equal.

Default risk is measured at a particular moment and for a particular investment horizon. Disney has almost a zero chance of default for the foreseeable future, but in perpetuity it has some. If you buy a Mickey Mouse bond today, the default premium embedded in the price is near zero. If the firm begins to quake in the future, its price will drop and yield will rise.

All bond pricing is reflected in the discounted cash flows. If you remember nothing else, remember that.

These hyper-long duration debentures also tend to have call features which add option risk and hence yield.

Wouldn't rates be lowest at the duration at which most liabilities/income needs are due. I think the thought exercise would imply a U-shaped curve with the nadir shifting as a function of many things including e.g. demographics

"Most of the late 19th century had an inverted yield curve. UK perpetuities were the “safe asset,” and short term lending was risky. It also lived under the gold standard which gave very long-run price stability."

How did that work when the UK went off the gold standard, and the value of its bonds went down by 75%?
Maybe investors are just smarter now, and do not ever believe that governments will be sufficiently disciplined. Since none in the history of mankind ever has been.

The long-term bond has more mark-to-market gains and losses, but you don’t care about that. You care about the long term payout, which is less risky.

Wait a minute. What about liquidity?

The long-term bond, as Cochrane says, fluctuates more in value than the short term bond. So if there is a risk you will need the cash before maturity - and of course there is that risk - then those fluctuations matter. They increase the risk of the bond, whether you look at the statements or not.

How confident is the long-term investor that the money can safely be locked up for thirty years, or ten for that matter.

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