Markets to Washington: You know nothing of our work

January 17, 2013

Markets are funny. Sometimes basic intuition tells you a lot: If there is a recession, the stock market almost certainly falls, for example; if there is high inflation, bond yields rise as investors demand compensation.

But sometimes, basic intuition is all wrong. This is one of those times. On a couple of key questions around U.S. policy, the conversation in Washington is getting two things about markets particularly wrong, clouding the debate on some of the most important policy debates of our time.

Markets can misprice assets and get things wrong, of course, sometimes for long periods of time. But they also reflect the combined knowledge of traders and investors around the globe, with trillions of dollars on the line. And understanding what markets are and are not telling policymakers is a first step to making better decisions. These are the two big things anyone who cares about America’s fiscal policy debates needs to know about the signals being sent from Wall Street.

The markets are not demanding deficit reduction now. This is the most widespread misconception among most Republicans in Washington, many centrists, and no small number of Democrats. The notion is that global investors are on a knife’s edge, ready to pounce and drive up U.S. government interest rates if we don’t enact a major deficit reduction package. There just isn’t any evidence from movements in the bond and currency markets that this is the case.

Consider the series of events since the middle of September. A vigorous campaign took place in which the odds of who would win the presidency gyrated regularly; the election led to four more years of the Obama administration and a continued Democratic Senate and Republican House; negotiations began to avert the “fiscal cliff” of austerity measures, in which many were pushing for a “grand bargain” of long-term deficit reduction. The talks broke down a few times, until ultimately a deal was struck that was nowhere close to a grand bargain, and did almost nothing to reduce deficits in either the short term or long-term.

In that time, the U.S. government’s borrowing costs fluctuated roughly between 1.6 percent and 1.9 percent, and the value of the dollar fluctuated within about a 2 percent range relative to other major currencies, displaying no consistent pattern. No matter how hard you squint at those graphs, there seems to be no consistent relationship between news pointing to progress or lack thereof on deficit reduction and moves in those two indicators.

Here is what happened to the U.S. government’s 10 year Treasury yield since mid-September.


The yield on 10 year U.S. government bonds since mid-September. (Source: Bloomberg)

One could argue that the small but noticeable rise in bond yields shown on the right hand of the chart reflects investors starting to fret about Washington’s failure to rein in spending. But that story isn’t consistent with what other markets were doing. In countries experiencing a debt crisis, like Greece, Portugal, and Spain in the last few years, government borrowing costs rise at the same time the stock market and other risky assets fall; investors are losing faith in the country’s economic future as a whole. That is not what has happened in the United States. Since the beginning of December, Treasury yields have indeed risen from 1.62 percent to 1.86 percent, but that has coincided with about a 4 percent rise in the stock market. In other words, what seems to be happening is investors becoming more optimistic about the economy and therefore shifting from less risky into more risky assets—not losing faith in the U.S. government.

A dysfunctional government can mean lower interest rates, not higher. A typical way of viewing the upcoming stand-off over raising the debt ceiling is that if there is no deal and the U.S. Treasury has to start delaying payment on some of its obligations, the result will be a catastrophic spike in interest rates.

It could happen, of course. We are in uncharted territory, and it seems strange to speak of a U.S. government default as being even the remotest of possibilities. But the track record from the last time the debt ceiling neared created some strange, even perverse effects.

At the end of July 2011, you’ll recall, an impasse between the White House and congressional Republicans brought the nation to the brink of default. Even after there was a deal, on August 1, Standard & Poor’s downgraded the U.S. government for its dysfunction.

Here’s what people may forget: From July 27 to August 10, 2011, the yield on 10 year U.S. Treasury bonds plummeted from almost 3 percent to 2.1 percent. Take that in for a minute: As  the U.S. government flirted with default and the credit rating was downgrade, implying higher odds of a future default, the cost of Treasury bonds rose and investors were willing to fling money at us at an even cheaper rate. (It is worth noting, though, that Europe was in a particularly dark phase of its crisis at the time as well, which likely contributed to the decline in Treasury yields).

It defies what you might expect: There is a virtual certainty that if a company had dysfunctional corporate governance in which one faction wanted to stiff bondholders, that company’s bonds would plummet in value and its interest rates rise. But government bonds are just different in some fundamental ways from corporate bonds. They are viewed, even for all the warts evident in how legislatures work, as the place to plow money when the world seems scary.

But the United States may not be an aberration: Japan hasn’t had stable governance for nearly a decade; it has had seven prime ministers since 2006—eight if you count new prime minister Shinzo Abe’s second run in the office twice. Here is what has happened to its borrowing costs in that time:


Japanese government bond 10 year yields. (Source: Bloomberg)

But the absence of crisp, decisive governance in the world’s third largest economy hasn’t led investors to flee its debt, rather dysfunctional governance has contributed to a stagnant economy that has led investors to plow more money into Japanese government bonds rather than riskier assets.  Ten year Japanese bonds haven’t yielded more than 2 percent since 2006, and have been on a fairly steady downward march since then. The greatest problem Abe is trying to combat is that the yen is too valuable, not that it has plummeted in value.

A default by the United States would surely be terrible for the U.S. and global economies. But not necessarily in the way many seem to think.

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