Things make sense till they don't, part 2 – OR – 2013 Krugman

Here’s a followup to my earlier post:

I just read Paul Krugman’s piece today on, of all things, the bond bubble. Or, I should say, the lack of one. He, like Moody’s analysts (yet unlike Warren Buffet and yours truly) discounts (in true academic—and inexperienced—fashion) what investment blokes like me believe to be commonsense.

The thing is; markets fluctuate. And when they reach extremes they tend to, ultimately, do so (fluctuate) in grand fashion. Yes, I know, Japan. Krugman loves to point out how Japan has remained mired (not his term) in a crazy-low interest rate environment for decades. And if you think the U.S. will be doomed to decades of stagnation as well, Krugman may be right. However, our stock market is (or may be) forecasting something altogether different. And, I suspect, given all the moving parts, there may be a dynamic or two unique to Japan. Of course if Krugman were the least bit objective he’d be exploring, and reporting on, those dynamics. In fact, he does indeed understand that long-term interest rates can be influenced by factors other than the Fed’s control over short-term interest rates. As he explained back in 2003, when he wasn’t so enamored with the then administration:

Last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits…my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt.

Wow! What an utter contradiction to virtually everything he’s written about budget deficits and money printing over the past 4+ years!

Now back to Krugman 2013: As for the Fed; if my math is correct, the Fed is currently buying up the equivalent of roughly half the treasuries that need to be issued in order to fund our present budget deficit. That leaves the other half to either yield, safety or dollar-support-seeking (Chinese, Japanese, maybe) investors. In theory, the investors buying the other half can stay around till the cows come home. The Fed, on the other hand, can’t (although Krugman may disagree). The bond market will begin selling off (to what degree no one knows) when investors decide their objectives will be better met elsewhere. Oh, and by the way, the ten year treasury closed today at a yield of 1.9%. That’s a 17% spike above this year’s low (which it hit about a week and a half ago). And that’s without the Fed changing a thing. Hmm…

And lastly, here he is, in his 2013 brilliance, explaining what makes a long-term interest rate:

Well, the interest rate on long-term bonds depends mainly on the expected path of short-term interest rates, which are controlled by the Federal Reserve. You don’t want to buy a 10-year bond at less than 2 percent, the current going rate, if you believe that the Fed will be raising short-term rates to 4 percent or 5 percent in the not-too-distant future.

Allow me to take a stab at it:

The interest rate on long-term bonds depends entirely on investor appetite for long-term bonds. You don’t want to buy a 10 year bond at less than 2 percent if you believe there are better uses for your money elsewhere, regardless of what the Fed does with short-term rates. An uptick in the economy can inspire (or scare, as they anticipate rotation) investors to other asset classes—forcing up bond yields—in a hurry. A too(?)-weak dollar, as 2003 Krugman feared, can do the same.

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