Murder by the Orient Economies?

Evan Soltas has a new post that examines two competing theories of why interest rates have recently been rising:

There are two theories of why interest rates are rising. In the first, they are rising because of an improved economic outlook, which leads investors to anticipate a swifter exit for monetary policy. In the second, they are rising because of a change in investor expectations of the monetary exit, independent of economic conditions.

Fortunately, statistics has a way of answering these questions: correlation. (Or at least, helping us answer these questions.) I downloaded the daily time series data of the 10-year Treasury note yield and the S&P 500 stock index from June 2008 through the present. If on days that rates are rising, the stock index also rises, then we can assume that both are driven by changes in the economic outlook. If on days that rates are rising, the stock index is falling, then the “economic outlook” story doesn’t hold up — and a “monetary policy” story fits.

I calculated the 90-day correlation coefficient of their daily percentage changes. I find that it has been plummeting since May, which is when interest rates began to jump. See how it’s falling off a cliff at the right end of the chart? That means the first story (“happy days are here again”) is wrong, and the second story (“the Fed is tightening”) is right.

.  .  .

If the Fed doesn’t intend for all of its talk since the start of May to be perceived as pushing forward the schedule for monetary tightening, independent of the economic recovery, it needs to start clarifying its intentions. Now.

It seems plausible that part of the rise in rates since May has been driven by positive economic news, but I agree with Evan that the recent sharp increases in interest rates mostly reflect expectations of tighter Fed policy.  And I think he’s provided the most persuasive evidence in the blogosphere for that view.

A couple days after I wrote this post (but before posting it) I started to have second thoughts.  Lars Christensen sent me the following by email:

This is not the doing of Bernanke. This in my view is nearly 100% driven by tighter Chinese monetary conditions – and the spike in US yields is driven by a flow story. There is a sharp rise in money demand in China, which is causing Chinese investors to sell everything to get liquidity – including US Treasuries. That is causing US bond yields to spike and it is also causing the collapse in inflation expectations in the US (and everywhere else).

And then in a later email (with permission):

Scott,
>
> I believe my “story” fits actual market events much better than a story about tapering. Just look at the magnitude of the movement in US yields – up 100bp in less than 2 months. That [would be] a major move based on Bernanke stating the obvious – “we will scale back if the economy is better and step up if it worsens” Should he had said anything else? I would have understood that yields would have risen if he had said “The economy is much better and NGDP is likely to grow by 6% year, but hell to that we will just continue QE no matter what”
>
> If “tapering” really was a monetary tightening – why did the dollar WEAKEN until a couple of days ago? And why do US stocks continue to outperform basically any other stock market with the exception of the Nikkei?
>
> Lars

Lars has been doing post after post on the China story, but I wasn’t paying much attention until today.  As anyone who follows the market knows, the sharp fall in stocks and rise in bonds yields today was widely attributed to problems in China.  Furthermore there was no news on US monetary policy.

So does that mean Evan was wrong?  I don’t think so, because we know that the big move up in yields after the Fed meeting, and again after the Bernanke speech, were linked to Fed policy.  And the fact that stocks broke sharply on the news suggests that the market viewed it as new information, and as a contractionary surprise.

But I also find Lars’ argument to be persuasive.  So I see two smoking guns, Bernanke and China.  Then you could add in the BoJ getting cold feet a few weeks back, which also sent US markets lower.  It’s starting to look like Murder on the Orient Express.

I’d like to say that interest rates don’t matter, only NGDP matters. And I often do say that. But unfortunately as long as central banks insist on targeting interest rates, a fall in the Wicksellian equilibrium interest rate and/or a rise in the Fed target rate impact expected NGDP growth.  And it looks like the events of the past few weeks have raised the expected future fed funds rate and (more recently) lowered the Wicksellian equilibrium rate.  Both shifts are contractionary.

Tyler Cowen also has some interesting posts on this topic (here and here).  Like Tyler (and Paul Krugman) I didn’t expect an end to the flow of T-bond purchases to have a big impact on T-bond yields.  I’m still not sure exactly how large the impact was, but Evan’s results, combined with the real time moves on last week’s Fed news, convinces me that if I did know it would probably have been larger than I expected.

One final point.  At the risk of sounding like a broken record, we really, really, really need an NGDP prediction market.  The sort of speculation you see in the posts that Tyler links to is intriguing, but the linkages are far too complex to figure out the implications for US aggregate demand without market signals.  We are still flying (half) blind.


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35 Responses to “Murder by the Orient Economies?”

  1. Gravatar of Marcos Marcos
    24. June 2013 at 18:14

    The economy is recovering? http://www.businessinsider.com/dallas-fed-manufacturing-june-24-2013-2013-6

  2. Gravatar of Evan Soltas Evan Soltas
    24. June 2013 at 18:44

    This is an interesting debate. I’ll keep my eyes out for evidence (contrary or supportive) for my side, and I know of an easy way to check Lars’ thesis — which, by my reading, seems to rely on panic sales of U.S. Treasuries. I don’t find that concept particularly plausible, given the 2008 flight-to-safety experience. The Bloomberg terminal has data on Chinese holdings of UST (HOLDCH: IND) which I will be able to access tomorrow. I’ll post a graph then.

  3. Gravatar of Scott N Scott N
    24. June 2013 at 19:35

    If tight money and low inflation produced high bond yields, then what theory explains the ultra low bond yields in Japan fobeginningr so many years?

    There was another time in the recent past when real yields skyrocketed and inflation dropped – fall of 2008. However, regular treasury yields are going up now and they were falling precipitsurprisinglyously in fall 2008.

    One more puzzle piece is that real yields started rising dramatically on the very day the jobs report was announced at the beginning of May 2013. That same jobs report has sucked badly for the past three years and has been one of the major catalysts for the summer stock market swoons of the post three years. It was only this year that it surprised to the upside. The implication being that the TIPS yields began to price in more real growth. It is also worth noting that the same story repeated itself in June (jobs report surprised to the upside and broke a three year string of bad June jobs reports and TIPS yields popped).

    Note too that the surprisingly positive May and June jobs were the major reason that so many began to forecast that the Fed would raise interest rates much sooner in the future. This is what leads me to believe we are one bad jobs report away from a major reversal in the bond market.

  4. Gravatar of Scott N Scott N
    24. June 2013 at 19:36

    Sorry for the typos. I’m writing on my tablet.

  5. Gravatar of Evan Soltas Evan Soltas
    24. June 2013 at 19:55

    The China data may be public here: http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt. Waiting on May numbers in mid-July.

  6. Gravatar of Johannes Fritz Johannes Fritz
    24. June 2013 at 21:36

    To me, the first theory is very much about the perception of where Fed decision making lies on the spectrum of technocratic political. Without thorough knowledge of the time, the Volcker rate hikes seem like a pretty technocratic policy choice. But now after finding themselves in the spotlight for five years, central bank decision making may have become more political. The reported echoes of bubbles and inflation by Fed officials sound like this to me.

    This FOMC statement caters to both ends of the spectrum. Thresholds for the technocrats, optimistic timelines for the politicians.

    Related but not entirely on topic, the comments by Richard Fisher in today’s FT remind me of an earlier discussion you had on this blog about “Generation Bubble”. Probably this is what the adverse consequences of excessive bubble vigilance are: pre-cautionary punch bowl withdrawal.

  7. Gravatar of This is why we need an NGDP futures market | The Market Monetarist This is why we need an NGDP futures market | The Market Monetarist
    24. June 2013 at 22:10

    [...] Scott Sumner and Evan Soltas have similar [...]

  8. Gravatar of dirk dirk
    24. June 2013 at 22:48

    I commented on MR about this but thought I might here too, FWIW. I’m no economist and am more used to thinking as a speculator in the market (i.e., a participant).

    To me, there are events within the calendar trading year which are likely to trigger big moves. Traders pay attention to the calendar and potentially big market days on it. Perhaps this causes certain “big events” to become self-fulfilling as “big events” merely because so many big traders are ready to respond to them with big bets. Nothing draws a crowd like a crowd… etc.

    It’s obvious that the Fed announcement moved the bond markets significantly. What’s less obvious, to me, is whether the content of the announcement mattered more than the “event” of it. For instance, it’s not uncommon for quant traders to view a market event such as an earnings announcement as “noise” to be ignored in terms of the numbers in the announcement but nevertheless a significant timing opportunity to enter the market based upon how other variables react to the announcement.

    So in my mind the Fed announcement was such a trigger, timing-wise, while the specific language in the presser may have meant little to big market participants who suddenly decided to place big bets.

    In other words, I have no problem believing that the bond market move after the Fed announcement was more about the content of China’s policies than the content of the Fed announcement, but that the Fed announcement was a trigger in the temporal dimension to the placement of big market bets.

    Your ideas about the preeminence of expectations are spot on. They hold for expectations of big market moves after a big Fed announcement. What did the VIX do leading up to the announcement?

    The public and even smart economists in the blogosphere ignore the subject of volatility compared to market direction. All we know for sure today is that the Fed announcement beget massively increased volatility. Do not underestimate the power of big traders in the market in the short run.

  9. Gravatar of Rob Rob
    24. June 2013 at 23:44

    What would be needed to set up a NGDP prediction market? Does it need to be operated by a government agency or could anyone (given sufficient funding?) operate one? How much funding would be needed?

  10. Gravatar of Vaidas Urba Vaidas Urba
    25. June 2013 at 01:34

    ” The sort of speculation you see in the posts that Tyler links to is intriguing, but the linkages are far too complex to figure out the implications for US aggregate demand without market signals. ”

    When 2017 Eurodollar trades away from its Evans Rule value, it is a market signal, and I don’t like this signal.

  11. Gravatar of J J
    25. June 2013 at 01:53

    Professor Sumner,

    I have a bunch of problems with this post. You reiterate what Tyler Cowen said about underestimating the effect of the flow of T-bond purchases. John Taylor pointed out that this wasn’t a flow change. A flow change would be an EXPECTED slowdown in purchases. An announcement that purchases may stop a year before they were previously expected to it is a change in the expected stock of purchases.

    Yet, the China story seems to be a story of flow change having an effect on interest rates. I’m not sure I follow Lars’ logic. If inflation expectations are lower and economic conditions are unchanged, then shouldn’t interest rates be lower too? And how can a temporary Chinese selloff impact 10-year rates? Does this mean that the arbitrage condition (10-year rates are the sum of expected short-term rates) no longer holds?

    Finally, to the extent that Evan Soltas is right, that is somewhat of a win for Krugman. He always suggested that the effect of monetary tightening on long-term rates is ambiguous.

  12. Gravatar of Ognian Davchev Ognian Davchev
    25. June 2013 at 02:13

    Ptof. Sumner,

    You can try getting funding for an NGDP futures market using the various crowdfunging sites. Like http://www.kickstarter.com/ for example.

    If I recall correctly you have mantioned $100 thousand as a required amount before. This is definately doable through crowdfunding.

  13. Gravatar of Murder by the Orient Economies? | Fifth Estate Murder by the Orient Economies? | Fifth Estate
    25. June 2013 at 02:17

    [...] See full story on themoneyillusion.com [...]

  14. Gravatar of F1 som start og senere konvertere til fast eller fast nu – Side 3 – Boligdebatten.dk F1 som start og senere konvertere til fast eller fast nu - Side 3 - Boligdebatten.dk
    25. June 2013 at 02:39

    [...] [...]

  15. Gravatar of Adding Knut Wicksell to the List of the Wrong | askblog Adding Knut Wicksell to the List of the Wrong | askblog
    25. June 2013 at 03:27

    [...] I would add myself to the list of economists who have some ‘splainin’ to do. I am always willing to be counted among those who doubt the Fed’s power over interest rates, especially long-term real rates. By the way, Scott Sumner used to say that a rise in long-term interest rates could be a bullish indicator. Would he say that now? UPDATE: No. [...]

  16. Gravatar of J J
    25. June 2013 at 03:43

    By EXPECTED I mean anticipated

  17. Gravatar of TheMoneyIllusion » Rising long term rates are usually a bullish indicator TheMoneyIllusion » Rising long term rates are usually a bullish indicator
    25. June 2013 at 04:42

    [...] I would add myself to the list of economists who have some ‘splainin’ to do. I am always willing to be counted among those who doubt the Fed’s power over interest rates, especially long-term real rates. By the way, Scott Sumner used to say that a rise in long-term interest rates could be a bullish indicator. Would he say that now? UPDATE: No. [...]

  18. Gravatar of ssumner ssumner
    25. June 2013 at 04:59

    Thanks Marcos.

    Evan, My intuition is the same as yours. But here’s the problem. Stocks and bond prices both fell sharply yesterday on the Chinese news. Whatever the cause of that drop, it wasn’t expectations of an end to QE–that was already priced in. So I regard it as a significant data point, even if the specific transmission mechanism discussed by Lars remains unproven.

    You are right that international turmoil usually raises US bond prices. So why didn’t it yesterday?

    Scott, Good points.

    Johannes, Yes, Fisher is obsessed with bubbles.

    dirk, Interesting. I suspect that the actual cause of recent events is surprisingly complex. If not the mechanism that you suggest, then something else equally complex, involving many countries.

    Rob, You’d need someone with deep pockets. People sometimes ask me to try to set one up. I don’t have the time, much less the money or finance skills. Someone else needs to do this; Harvard, the US government, Goldman Sachs, or someone else with deep pockets. Someone willing to put in a few hundred thousand a year in subsidy, at least (maybe more.)

    Vaidas, You’ll have to explain that. How do interest rate futures tell us anything about future inflation and unemployment?

    J, You said;

    “Finally, to the extent that Evan Soltas is right, that is somewhat of a win for Krugman. He always suggested that the effect of monetary tightening on long-term rates is ambiguous.”

    So have I–from day one. Indeed that’s the standard textbook view.

    I don’t follow your comment about stocks and flows. Any change in the flow of new purchasing will impact the expected future stock at a given point in time.

    Ognian, See my reply to Rob.

  19. Gravatar of J J
    25. June 2013 at 05:13

    Professor Sumner,

    You said: “I don’t follow your comment about stocks and flows. Any change in the flow of new purchasing will impact the expected future stock at a given point in time.”

    The flow view is that even if the Fed announces it will stop purchases a month ahead of time, the interest rate will move when the Fed actually stops purchases. The day-to-day flow is holding down interest rates. The stock view is that the Fed can adjust the interest rate by changing the available stock of an asset; if the Fed buys enough treasuries, then they will be more scarce and the price will go up. The day-to-day flow is quite insignificant compared to the stock of assets.

    If the Fed announces that it will stop purchases a year before was expected, then it is (as Taylor pointed out) adjusting the expected future stock of treasuries by possibly more than a trillion dollars. If the Fed decides to stop purchases today and they were expected to stop in a week, then the flow greatly changes but the stock and the expected future stock remain unchanged. The flow view would predict a change in interest rates; the stock view would not.

    Of course, it’s possible that I am completely misunderstanding these concepts.

  20. Gravatar of Is Tapering Tightening? Fed Policy in Two Charts | Donald Marron Is Tapering Tightening? Fed Policy in Two Charts | Donald Marron
    25. June 2013 at 05:20

    [...] something else happened. Scott Sumner discusses one possibility: turmoil in China’s financial sector spilling over into U.S. [...]

  21. Gravatar of Nick Nick
    25. June 2013 at 05:45

    “If tight money and low inflation produced high bond yields, then what theory explains the ultra low bond yields in Japan fobeginningr so many years?”

    Little real growth, few private investment opportunities, so government bonds look relatively better even at low yield.

  22. Gravatar of Joseph Joseph
    25. June 2013 at 08:52

    Is it possible that it is the stock of bonds that still matters but that at the current rate so many are being added to the stock by the large federal deficit that without offsetting Fed purchases the stock would grow at a significant rate. An earlier than expected exit from QE would lead to significantly higher expected stock of bonds later.

    The current flow of bond purchases has not altered only expected future flows which also implies altered expected future stocks.

    Without looking at any actual data, as the deficit has fallen over the past few years at quicker than anticipated rate and so have long term yields.

  23. Gravatar of The long bond yield ‘conundrum’ | Historinhas The long bond yield ‘conundrum’ | Historinhas
    25. June 2013 at 09:13

    [...] What´s the ‘meaning’ of the rise in the long bond yield after May 1st? This is being widely discussed. Evan Soltas did a post a few days ago which was picked up by Scott Sumner. [...]

  24. Gravatar of Good marginal revolution posts for today | TVHE Good marginal revolution posts for today | TVHE
    25. June 2013 at 11:39

    [...] a strange reaction for an announcement that in many ways should have been expected!  [Add this from Money Illusion, and all the links within - the simultaneous events in the US and China make this a messy thing to [...]

  25. Gravatar of Vaidas Urba Vaidas Urba
    25. June 2013 at 12:24

    Scott,
    2017 Eurodollar contracts are market forecasts of Fed’s policy in 2017. Bernanke has shifted the Evans rule in the dovish direction during the press conference. You can take your unemployment and inflation forecasts from any market source you like, including the treasuries, but the 2017 Eurodollar contract has crashed. According to the updated Evans rule and according to the changes in market forecasts of growth and inflation, 2017 Eurodollar should have traded at roughly the same levels, if not higher. The only possible conclusion is that interest rate markets are seeing risks of 2017 monetary policy that is much tighter than the current FOMC would like.

  26. Gravatar of wawawawa wawawawa
    25. June 2013 at 14:45

    So, basically Dr Sumner and Evan are saying that the markets don’t believe the Chairman’s comments of policy being goal (and not calendar) dependent? Or maybe, regardless of macro data and Fed goals (ie: if URate=5.5% and core PCE=2%), the market is going to kickback at ANY hint of Fed pullback

  27. Gravatar of Saturos Saturos
    26. June 2013 at 01:39

    Bryan Caplan has a question for you about this post: http://econlog.econlib.org/archives/2013/06/vindication_by.html

    To me the surprise was more about the direction of the movement in longer yields, given that the policy surprise was contractionary.

  28. Gravatar of ssumner ssumner
    26. June 2013 at 05:56

    J, Sounds like the flow view has never heard of the EMH.

    Nick, No, rates depend on NGDP growth, not RGDP growth.

    Vaidas, I’ve never seen any unemployment forecasts for 2017, and I can’t imagine they’d be reliable, even if they existed.

    wawawawa, My complaint is slightly different. Even if it is goal driven, the Fed should be INCREASING its purchases right now, as they will fall short on both the inflation and employment front.

    Saturos, Thanks, I left a comment.

  29. Gravatar of J J
    26. June 2013 at 07:16

    Professor Sumner,

    You said: “J, Sounds like the flow view has never heard of the EMH.”

    I agree completely. The flow view is absurd. Tyler Cowen suggested that he and Paul Krugman had to rethink their opinion of the flow view. He was referring to many claims by Krugman that there would not be a spike in interest rates as soon as the Fed actually stopped purchases. I don’t see how the Fed announcing that it will stop purchases earlier than previously expected is at all the same as actually stopping purchases at an anticipated time. The former affects expected future stocks. The latter simply affects the flow and has no impact on stocks.

  30. Gravatar of Vaidas Urba Vaidas Urba
    26. June 2013 at 11:53

    Scott,
    but if Fed’s policy framework is credible, the pricing of many assets depends on the unemployment in 2017, and price changes provide us the information about the change in 2017 unemployment expectations. And we still have a conundrum – changes in inflation and unemployment expectations predict the same or lower rates in 2017, LIBOR contracts say the rates will be higher. So the markets started fearing a risk of sharp premature tightening in 2017 when they listened to Bernanke’s conference.
    Bottomline – NGDP futures would be very useful in estimating the magnitude of Fed’s tightening, but there is enough data in all other markets to be sure that it was Bernanke who tightened the policy.

  31. Gravatar of Wawawa Wawawa
    26. June 2013 at 13:41

    I understand your complaint. This doesn’t however impact the recent market reactions. The market didn’t react on what they think the fed SHOULD be doing but rather what they think the fed WILL do. So, do you think they don’t believe Bernanke’s statements? Is this similar to Krugman’s thoughts on credibility?

  32. Gravatar of What do higher interest rates mean for stocks? What do higher interest rates mean for stocks?
    30. June 2013 at 09:56

    [...] most realize. He wisely notes other influences on interest rates – not just the Fed. Read his “Orient Express” post and follow the links if you want to understand the academic [...]

  33. Gravatar of Indicator Update: What do Higher Interest Rates Mean for Stocks Indicator Update: What do Higher Interest Rates Mean for Stocks
    1. July 2013 at 07:05

    [...] most realize. He wisely notes other influences on interest rates – not just the Fed. Read his “Orient Express” post and follow the links if you want to understand the academic [...]

  34. Gravatar of Weighing the Week Ahead: What do higher interest rates mean for stocks? topic | Sell1buy Weighing the Week Ahead: What do higher interest rates mean for stocks? topic | Sell1buy
    12. July 2013 at 06:07

    [...] most realize. He wisely notes other influences on interest rates – not just the Fed. Read his "Orient Express" post and follow the links if you want to understand the academic [...]

  35. Gravatar of ウェディングドレス 中古 ウェディングドレス 中古
    18. August 2013 at 16:23

    万年筆 ラミー

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