March 27th, 2012
by Andrew Butter
The last time the yield on the 10-Year US Treasury dipped below 2% was in 1941; just before (not just after), the Japanese attack on Pearl Harbor.
If history rhymes, the recent 1.8% low might not have been caused just by a combination of Euro-refugees plus the interference of central banks; perhaps we are on the cusp of another blitz of Black Swan tail-risks potentially as devastating as World War II, or there again perhaps not?
This article is a continuation of a series started two years ago which correctly predicted the 10-Year was headed to below 3%. Back then that notion was a minority; some analysts were predicting more than 6% by 2012.
Now some of those same experts are saying less than 3% or thereabout will be around for a while; although it’s not crystal clear whether the theory behind the new idea is a spanking brand-new one, or if it’s the same one that predicted 6% or more, just dusted off a bit?
Not that many experts are making specific predictions these days…the art, science, or psychic wonder of prediction seems to have a bad name. It wasn’t always like that, in 1953 Milton Friedman wrote: “The question whether a theory is realistic “enough” can be settled only by seeing whether it yields predictions that are good enough for the purpose in hand or that are better than predictions from alternative theories.”
So, according to Friedman, did “below 3%”…settle it?
Perhaps…although that was just one prediction and the chance it could have been made by a lucky guess is about one-in-40; which is the same probability that when Paul the Octopus correctly predicted the results of five FIFA World Cup matches in a row it was a fluke, rather than thanks to his theory or perhaps because he was psychic.
All you can say for sure is the theories which predicted 6% were definitely wrong; as wrong as the theories that “house prices will go up forever” and that there were hundreds of WMD there were in Iraq ready to launch on 45-seconds notice.
The other one might be right, but there again it might not; it was based on two ideas:
1: You can use International Valuation Standards to value anything (Treasuries have a value). Granted that’s not exactly a radical theory, given that those standards are agreed by every valuation society in the world to represent the best way to do valuation, not that anyone uses them, particularly not FASB, IASB or BIS.
2: The General Theory of the Pebble in the Pond which says in times of bubble & bust, E2 = MC. Where in times of market disequilibrium [E] is the equilibrium (or other than market value if you use International Valuation Standards), [M] is the minimum after the bubble pops, and [C] is the crest of the bubble; assuming of course that the equilibrium is constant, if it’s not it gets (a little bit) more complicated.
How does that work?
The valuation side of the prediction (Step-1); is to figure the “equilibrium” or what International Valuation Standards calls other than market value. That loosely translates as the price the market ought to be if it was not going through a period of disequilibrium, which is a word sometimes used to politely describe outbreaks of collective mass-stupidity.
In this case the valuation was based on the theory that there is a causal relationship between past nominal GDP growth and the yield on the 10-Year; here’s a chart:
That’s not a new idea, a recent article in Forbes told us in the words of one syllable that trained-economists reserve for the intellectually challenged, that “traditionally” the yield on the 10-Year was driven by a combination of expectations of “real” economic growth plus inflation (presumably in operating costs not assets), plus a risk premium. Err…I thought you got to “real” economic growth by taking inflation away from nominal and I can’t understand why there is a risk-premium for risk-free assets, or indeed why economist to use ten words when two would suffice.
Anyway, that’s sort of right, but only up to a point; (a) the relationship is not linear, it’s an S-Curve; (b) trailing nominal GDP works much better as an explanatory variable than either “expectations” or what actually came to pass (c) it’s not a particularly good correlation. Here’s another chart, the blue line and dots is 1900 to now; the red line and blue dots with red-inside is since 1980:
Notice there is a big difference between where yields flatten off on the right hand side (9.5% for the full data-set and 13% for since 1980), obviously one of those two lines, or both, has to be wrong. The R-Squared is OK for the 1980 to now line (the red one…78%) but pretty lousy for the 1900 to now one (the blue one…42%), of course that doesn’t mean the red line is better than the blue one. But at least on the part of the curve that is relevant to today, there is a consistency.
So what’s the rest of the story?
Two options, either there are other variables which might be teased out by say multivariate analysis, with the risk of auto correlation, or the story is that there was a lot of disequilibrium, as in bubbles and busts pull the price (yield) one way or another.
The logic for why there might be a (sort of) correlation, and that might be a valid explanation for what happened, or at least a part of one, not that it matters because this article is explicitly about prediction not the rhyming of history, could be that when nominal GDP is growing (whether that’s inflation or “real” is completely irrelevant); companies, people want to do things, they see opportunity, so they want to borrow so they can gear a 12% project IRR to a 20% investment IRR.
The way it works is that when a load of people roll up at the bank wanting to borrow money, what do the bankers do? They peek out the window, notice there is a queue, and put the interest rates up so that you have to pay more to borrow. By the same token, like now, when there are hardly any people who can qualify to borrow who aren’t rolling in cash so they don’t need to, so the bankers make borrowing cheaper for the shrinking minority who can qualify for a loan, and want one.
On top of that, and more important perhaps for now, when the biggest banker in town doesn’t have to rely on depositors and can just print money, they can make a profit so long as the interest they get is higher than the cost of paper. But of course, the question remains, is that “real”?
That’s all another way of expressing the Daisy Principle which says that you can only milk a cow so much before she drops down dead, also called the Theory of Parasite Economics. Those two theories say that insofar as lending money is concerned, as a business model, it’s pretty much like selling crack-cocaine. Demand is effectively infinite and profits are huge so long as you don’t get busted and you can’t run fast. When supply effectively infinite, you just need to consider the possibility that once your customers are hooked if you cut the margin to increase the volume so you can maximize your ROI, a proportion of those customers might just drop down dead.
That’s what happened in the housing bubble and bust, supply of debt went up thanks to the genius of Fannie and Freddie and securitization (nothing to do with interest rates, they just followed the daisy-chain), and sure enough, there was a collective overdose. The moral of that story is next time you self-medicate, be sure you get dose right, because what might happen next, if you don’t, is not a tail-risk, it’s a heads-or-tails risk.
Step 2: The Theory of the Pebble in the Pond
OK so we got an estimate for the equilibrium-line, not that it’s particularly good, but you got to work with what you got. If disequilibrium was what pulled price/yield away from the equilibrium, then that may provide a direction to explain the other 55% of the changes in the data from 1900 to now?
The idea there is that when there is a bubble, the structure of the bust that follows is predicated by what happened before. That’s not a new idea, its history rhyming if you like or what Ludwig von Mises called the “tedious process of recovery”. Bob Farrell had a similar idea when he talked about excesses from the equilibrium one way being followed by excesses the other way, and of course there is that one about “what goes around comes around”.
I call it the pebble in the pond, because every bubble needs someone to throw a stone, to disrupt the natural balance of the market, and like a pebble thrown in a pond, the net result is zero-sum. Because for everyone who sold something at a price more than the equilibrium there has to be someone else who paid too much. Just like a pebble thrown in the pond does not raise the equilibrium level of the pond, a bubble and bust creates no net economic value added because for “real” economic value added, both sides of a transaction must gain.
So to get a second opinion on where the lines end up, top and bottom, you look for the ratio of mispricing, if the bubble mispriced by a factor of two at its peak (i.e. the equilibrium was 100 but the price went up to 200), then you expect the bust to be 50% of the equilibrium.
Plotting 100-Years and adjusting the variables on the first algorithm to fit the theory of the pebble in the pond, you get this:
When I first saw that chart I thought, “Nah that can’t be right”, could it be possible that US Treasuries can bubble and bust, AND that the cycle from start of bubble to end of bust is 70-Years. That’s really hard to believe.
But if that’s right that says first that the efforts of central banks to control fiat currencies, for the greater good, was a pretty lousy, and quite probably did more harm than good; and that in the end, like every time you mess with nature, and markets are an expression of a natural process, what goes around, comes around.
So if that’s right:
1: The regression of the full data (i.e. since 1900) is probably the right one, because the line from 1980 was only part of a cycle, and you need a full cycle, from start of bubble to the end, at least one, to do a valuation; which is why International Valuation Standards says you have to check you have “sufficient…market-derived data”.
2: Re-working that data says the bottom of the S-Curve is 2.7% which sounds about right, and the top is 5.9% which is also hard to believe, that says when the 10-Year was 15% that was a massive bust…caused perhaps by the preceding bubble, although that end of the curve is academic at the moment.
3: Looks like Mises might have been right about all that boom-bust stuff and that suggests a strategy of extend and pretend aided by keeping interest rates lower than the fundamental, extended the damage of The Great Depression…and could extend the damage this time, like it did in Japan?
4: By the same token, perhaps after the Volker Peak, interest rates on the long-end, were artificially high, perhaps caused by the Pebble in The Pond Theory, although truth be told.
5: Hard to believe yes, but that might explain why over the past thirty years you could make as much, sometimes more, just sitting in US bonds rather than by investing in US stocks. That could also explain the driver of creative ways of manufacturing new-fangled forms of debt, because that was easy money…until it wasn’t.
6: That might also go some way to explaining why the performance of the US economy (the “real” part not the bubble/bust part), was so lackluster over the past twenty years, money was expensive and it made more sense to invest, and create jobs, outside USA.
7: That said, the notion that keeping the 10-Year high immediately after a bubble bursts, like in 1929, looks like it was a bad idea, and there is a good argument to say Ben Bernanke did the right thing by reacting quickly and decisively; and the Euro-crowd did the wrong thing by vacillating. If that’s right, the danger now is the over-cheap money will cause a new round of bubble…and then bust; although equally, controlling mal-investment caused by outbreaks of collective mass stupidity, by the expediency of austerity, is not necessarily the way to go either; it’s hard to balance those two extremes when you don’t have good navigation tools.
The test of Black-Swan Pudding…is in the eating:
That’s a theory, if it’s right, and it’s useful, then it can be used to make a prediction.
What went wrong just after the 1929 crash was they vacillated, the 10-Year yield stayed (relatively) high for five years, Ben got that part right; the second mistake was after that, they went overboard the other way creating twenty years of boom-bust.
So lets assume, having got one thing right, Ben doesn’t blow it in the second round; although the commitment to keep playing with something that based on past performance, he probably doesn’t fully understand…until 2014, sounds ominous.
But if there is to be a happy-ending some time in the near future, then the current round of policies that are depressing the yield on the 10-Year below what’s “natural”, will get softly scaled back over the next two years; as the (nominal) growth of the US economy starts to tick up, albeit on four cylinders, jobs start coming back and securitization (done properly) re-starts; and let’s assume no one does anything REALLY stupid, like embarking on some more Rambo-wars.
If so…BIG IF…the bubble in Treasuries will pop.
This analysis says Treasuries were 180% over-valued at a little under 2% (value is the reciprocal of yield), so expect, that when there is a pop; then they will be under-valued for a while and yields will be 1.8 x the equilibrium.
But the equilibrium will go up too; perhaps the 2-year moving average of nominal GDP will go up to 5% in which case the “equilibrium” yield will go up to 3.8% so the yield at the top of the bust will go up to 6.27%, before dropping back to about 4% (by then the equilibrium will probably have gone up a tad more).
This is how that looks on the yield:
That’s a prediction:
The 10-Year Treasury will go up above 6% within three years.
There is a caveat. No I’m not trying to wriggle out of my prediction, but there are some major headwinds that might interfere with the “natural” process of the central banks getting out of the kitchen.
First if the policy is to go for the easy-win of boom and bubble to wipe away all the mistakes of the housing bubble in one go, the day of reckoning will be delayed, which will mean that when the bubble pops, it will be a bigger pop. If yields stay below 3% even when nominal GDP is growing, that would indicate a sustained over-valuation, which could mean that unless nominal collapses again the bust could take yields up to 10%, when that happens, in perhaps five years time.
There are also a lot of folks who might be disturbed by a spike in yields up to 6%, notably the US Government which would have to pay a lot more interest to issue new debt and to roll over the stuff they have. So they will face a conundrum, either cut off the green shoots at their knees and constrain the sort of economic activity that can pull America out of the hole she has dug for herself, or just bite on the bullet, and let nature take its course.
Equally, perhaps a theory that based on the evidence so far; has a one-in-40 chance of being wrong with respect to Treasuries…is…Err… wrong?
Time will tell.
About the Author
Andrew Butter started off in construction in UAE and Saudi Arabia; after the invasion of Kuwait opened Dryland Consultants in partnership with an economist doing primary and secondary research and building econometric models, clients included Bechtel, Unilever, BP, Honda, Emirates Airlines, and Dubai Government.
Split up with partner in 1995 and re-started the firm as ABMC mainly doing strategy, business plans, and valuations of businesses and commercial real estate, initially as a subcontractor for Cushman & Wakefield and later for Moore Stephens. Set up a capability to manage real estate development in Dubai and Abu Dhabi in 2000, typically advised / directed from bare-land to tendering the main construction contract.
Put the unit on ice in 2007 in anticipation of the popping of the Dubai bubble,defensive investment strategies relating to the credit crunch; spent most of 2008 trying to figure out how bubbles work, writing a book called BubbleOmics. Andrew has an MA Cambridge University (Natural Science), and Diploma (Fine Art) Leeds Art College.