Are Bond prices decoupling from the expectation of inflation?

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Russ_H's picture
Russ_H
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Are Bond prices decoupling from the expectation of inflation?

There has been much talk recently about Bond prices and their link to inflation. Is it possible to argue that that that link has been broken?. My thinking is as follows: The level of Bonds issued is so high and Governments have no option but to sell them that in effect they are a forced sale. In any forced sale the buyer dictates the price and they will do so on terms very favourable to them and the seller has no option but to accept them. This means the buyer is less concerned with inflation and can impose onerous terms on the seller even if they think that inflation will fall. Is this thinking reasonable? I would be interested in what the panel thinks.

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SamLinder
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Re: Are Bond prices decoupling from the expectation of ...

Russ,

What you say makes sense to me. However, as can be seen below, what seems logical to us doesn't always work out that way in reality!

ABC News

Yield on 30-Year Bond Falls After Auction

Treasurys rise, sending yields lower, after auction of $11 billion in 30-year bonds

By MADLEN READ

The Associated Press

NEW YORK

Beaten-down Treasurys are looking like a good deal again.

Investors moved back into the Treasury market Thursday after a surprisingly strong auction of 30-year bonds, pulling yields down from multi-month highs.

Treasury yields are closely tied to interest rates on mortgages, and both have been rising for several weeks as investors worried about inflation. Freddie Mac said the average rate for a 30-year fixed home loan spiked to 5.59 percent this week, the highest in seven months, leading to a slowdown in refinancing activity.

The U.S. Treasury Department offered a yield of 4.72 percent to lure in buyers — the highest yield offered at a 30-year bond auction since August 2007, but lower than the market anticipated.

The auction got plenty of bidders. The ratio of bids to bonds sold was 2.68 percent, much higher than the 2.14 ratio at last month's auction of 30-year bonds.

Demand from other countries appeared very strong. Indirect bidding, which usually consists largely of foreign bids, contributed to nearly half of the total bids accepted. Investors had grown concerned on Wednesday about foreign demand after a Russian central bank official said the nation was considering reducing its U.S. Treasury holdings.

Many investors decided Thursday that those fears were perhaps overblown.

"I don't think the foreigners are going to abandon the Treasury market," said John Spinello, bond strategist at Jefferies & Co. "They can't afford to abandon the Treasury market."

The 30-year bond rose in afternoon trading, sending its yield down to 4.69 percent. Ahead of the auction, its yield rose as high as 4.84 percent, its highest since October 2007.

The 10-year note also gained in price. Its yield — which is most closely linked to mortgage rates — fell to 3.86 percent after hitting 4.01 percent in earlier trading, the highest level since last October.

<More>

Russ_H's picture
Russ_H
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Re: Are Bond prices decoupling from the expectation of ...

Yes, there appear multiple vectors in the Bond price and fear of inflation is just one of them. Certainly no one with large Bond holdings would want the market to collapse overnight and they have to buy, so that will tend to force the price lower. However someone who is looking at it from an investment perspective may look at it from the view "you have to sell them, give me a good yield I dont give a stuff about inflation" so that vector is for the price to go up. What the overall price vector is of course is determined by the final price which seems to be upward. This seems to point to deflation as mortgages will go up house prices will be depressed further leading to less spending all round, a further round commercial property price reduction. This would affect the Banks capital asset reserve ratios leading to less lending and back where we started. Cue more QE.

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Farmer Brown
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Re: Are Bond prices decoupling from the expectation of ...
Quote:

There has been much talk recently about Bond prices and their link to inflation. Is it possible to argue that that that link has been broken?. My thinking is as follows: The level of Bonds issued is so high and Governments have no option but to sell them that in effect they are a forced sale. In any forced sale the buyer dictates the price and they will do so on terms very favourable to them and the seller has no option but to accept them. This means the buyer is less concerned with inflation and can impose onerous terms on the seller even if they think that inflation will fall. Is this thinking reasonable? I would be interested in what the panel thinks.

Hi Russ,

I am not sure I follow what you're saying. 

Quote:

The level of Bonds issued is so high and Governments have no option but to sell them that in effect they are a forced sale.

  Government, in this case the US government, determines the quantity and terms of the bonds to be sold.  They "don't have an option but to sell them" in the sense that since they run a continuous and ever-rising deficit they do have to raise money from somewhere, so I would agree with that statement, but they do get to decide the maturity and volume of bonds in each particular auction.  How the market reacts is another matter.

Quote:

In any forced sale the buyer dictates the price and they will do so on terms very favourable to them and the seller has no option but to accept them.

In a truely free-market auction, I would argue that the terms are dictated by the market, which in a competitive bidding process are produced by the various market-players, openly competing with each other, with the ones offering the best terms to the Seller, winning the auction.  In this particular type of auction - i.e., the auction of Treasury bonds, the government has the right not to accept bids if it so wishes, for example if there were not enough bids to absorb all $11 billion of debt below a particular interest rate, then the government could just accept the ones that were below its price-point.  That would be deemed a "failed" auction because not all the debt was absorbed.  That happened in England a few weeks ago.

What I am trying to explain is that the Seller does have some leverage.  The Seller dictates a minimum interest-rate (which I do not believe we have access to), and the Seller can always say "no" to any or all bids.  Failue for the US Treasury to complete an auction would be earth-shaking news, but they do have the right to not accept bids.

All this brings me to the "bid-to-cover" ratio, where I hope someone can help us out.  It is my understanding that the BTC ratio is simply the total amount of money offered (regardless of the interest rate demanded) divided by the total amount of debt offered.  If that definition is correct (Chris, someone, please help!), then the BTC ratio may be very misleading because it gives no indication of whether the "overage" was at an interest rate even reasonably close to what the government would accept or if it was within the competitive range of interest rates at which the auction was done. 

For example, let's just say there was a BTC ratio of 2 on an auction of $10 billion which ended with an interest rate of 4% for 30yr bonds.  That means a total of $20 billion was offered, only $10 billion was auctioned, and the highest interest rate accepted by the government was 4%.  We do not know what the low, high, or average rate of interest for the $10 billion that was not accepted was.  And, since "indirect" bidders usually take 1/3 - 1/2 of the auctions these days, it could be said that the BTC ratio of "market-bids" was really more like 3:1 or 4:1.  Without knowing what the interest rate spread of the non-accepted bids was, there is a lot we do not know.  What if the average rate was 5%?  What if it was 8%?  That's quite a big difference and would shed a lot of light into what the market forces may be saying.

It is my unsubstantiated suspicion that there was some real fear on part of the Treasury with this last 30-yr auction, which is why they auctioned off a very small amount compared to more recent auctions.  It was an amount so small that Geitner could have bought the whole thing with a click of the mouse on his Quickbooks program if need be.  Indirect bidders bought their usual chunk.  I'll bet they would have bought a lot more if the direct bidders bid the yield up in any meaningful way.  I believe they go into these things with a price-point (interest-rate point) already in mind, and are prepared to inject more money into the auction through indirect bidding in order to keep the rates where they want them.

They will not be able to do this forever, to be sure, but it is easy to see how they could manipulate these auctions, especially a measley $11 billion one, to a great extent. 

 

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JAG
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Re: Are Bond prices decoupling from the expectation of ...

 Russ,

I think your right to not jump to the conclusion that the bond market behavior is necessarily signaling inflation. Some financial commentators have pointed out that the rise in the 2 year last week is signaling another credit crisis is close at hand, which will surely be another deflationary event. And then you have Denninger's comments a couple days ago: 30y Bond Results: Beware

All those experts that said deflation wasn't even possible, are now saying that it is over. If you look at Japan, all their QE did was to stretch their deflationary correction event from 3-5 years in length to 20 years in length and counting.

Just my "deflation" adjusted two cents.

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Russ_H
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Re: Are Bond prices decoupling from the expectation of ...

 

Hi Patrick,

 

Quote:

In a truely free-market auction

If you /have/ to sell something then it is not a free market, is that correct?.

 

Quote:

What I am trying to explain is that the Seller does have some leverage

  Only insamuch as a Bond price collapse would do some potential buyers more harm than not buying them. Some potential buyers can buy stocks, gold or whatever and will not be influenced by this. It seems to me there are multiple vectors and a potential for chaos. I am not sure if any one can say which one will win out but would be interested if any one has any ideas.

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