Wednesday, June 20, 2012

Operation Un-Twist

This morning's WSJ has a great piece by Todd Buchholz, titled "Washington Should Lock in Low Rates" This is in the context of increasing speculation that the Fed will do another "operation twist," buying long term bonds and selling short term bonds in an effort to drive long term rates even further down.

Long term rates are absurdly low.

I don't know who in their right mind is lending the US government money for 10 years at 1.59% and for thirty years at 2.67%. You have to believe inflation will be lower than these values just to get your money back, let alone make any real return.  (The best I can do is to opine that these are not long-term investors, and they think they can get out before rates rise. I will admit that understanding such low rates is stretching my rational-investor efficient-market prejudices.)

Well, no matter. When offered a screaming good deal, you should take it!

Restructuring US debt to longer maturities has all sorts of advantages. (Restructuring. I am not advocating stimulus!) It buys lots of insurance, very cheaply.

Think about what happens with very long term debt vs. rolling over one or two year debt, which is what the US does now.  Sooner or later, interest rates will surely rise to normal, 5-6%. If we are rolling over debt, that means the US Treasury has to come up with an extra 4-5% times the outstanding stock of debt, each year, to pay interest. 5% of $15 trillion is $750 billion, more than half our current (and already unsustainable) deficit. Oh, and by then the debt will be a lot more than $15 trillion by then.

And that's just the "return to normal" scenario. What if the exploding euro leads bond investors to wake up that all debt of highly-indebted, sclerotic-growth, perpetual-deficit, can't-cure-runaway-entitlement governments is dubious?  Greece didn't get in trouble trying to borrow for one year -- it got in trouble trying to roll over debt. If that moment comes and the US has lots of long-term debt outstanding, it just means a mark-to-market loss for bondholders. If we are rolling over short term debt, then the debt crisis comes to the US. And there is no Germany to bail us out.

Todd goes beyond the usual 30 year Treasuries, and advocates 50 or 100 year Treasuries. Good idea! I have wilder ideas. We should think about bonds with no principal repayment at all. 30 years of coupons, or even perpetuities. These bonds never have to be rolled over -- you never have to issue new debt to pay off the principal of the old debt. Or, if we want to maximize the duration of the bonds, issue the opposite: zero-coupon 50 year bonds.  At least that puts off any problems for 50 years!  If restructuring physical debt is hard, do what the private sector does: Massive fixed-for-floating swaps could lengthen the US maturity structure very quickly without unsettling somewhat illiquid markets for seasoned bonds.

Lots of smart money is locking in absurdly low rates. Why not the US?

The Treasury is trying, a bit. But the Fed is undoing what the Treasury is trying with "twist." And the Treasury isn't going nearly long enough, in both my and Todd's view.

Why is the Fed undoing even the Treasury's small lengthening? The Fed seems to think that shortening the maturity structure will lower long-term rates, and this will stimulate the economy. I doubt it can lower long term rates at all, but we don't have to fight about that. Even if it could lower 10 year rates another, say, 15 bp, from 1.59% to say 1.44%, really, how much stimulation would that accomplish? Is the economy really sluggish (and it is) because it's strangling on 1.59% -- substantially negative in real terms -- 10 year benchmark rates?

Todd takes a darker view.
The short answer is: out of shrewd political self-interest...borrowing short gives the illusion of a lower budget deficit, flattering President Obama's fiscal profile—if anything can flatter a deficit-to-GDP ratio approaching 9%.

With a generous Federal Reserve squeezing short rates down to zero, the interest cost of existing debt looks pretty meager at 1.4% of GDP. But this is a terrible trade-off that makes President Obama look better while almost guaranteeing that our children are worse off. Issuing 100-year bonds, or at least 50-year bonds, would require a higher interest rate, perhaps 3%. Sure, that would put more pressure on near-term deficit reports. But leaders should be willing to let their personal image take a dent if it clearly helps the American people. Locking in 100 years of borrowing at a 3% rate would be the best deal since Pope Julius paid a pittance to have Michelangelo paint his ceiling
To emphasize what Todd says very briefly, borrowing short only helps deficit "reports," and gives the "illusion" of a lower deficit. Standard budget accounting does not mark to market, so borrowing at 3% yield for 50 years counts as 3% interest cost, even though the one-year return on the bonds may only be zero -- the government could buy back the bonds next year at appreciated prices, and the carrying cost is zero. 

Is this really they story? I don't know anything about politics, but it is tough to believe. As Todd points out, what's another drink among sinners? If you weren't bothered by 9% deficit-to-GDP, you probably think of another percent or so as valuable fiscal stimulus. If you're an anti-Obama, he's-spending-us-to-oblivion Tea Partier, it's hard to see that an extra percent or so of bogus-accounting interest cost is going to make you feel that the Administration is serious about deficits.

Moreover, surely the Administration hopes still to be in office in four years, and hopes the economy returns to normal growth, which means normal interest rates, by then. This isn't about "our children," this is about us, very soon. If they're doing it for political calculus, they are cooking their own goose. (Or maybe Hilary Clinton's goose!)

I think the answer is much simpler. "The right maturity structure of government debt" is something economists haven't thought about much, the functionaries in charge at the Treasury have thought less about, certainly in these big-picture terms, and the higher-ups at Treasury and in the political parts of the Administration even less so still. They've got enough on their hands.

If my theory is true, that people just haven't thought about what a great deal markets are offering, and how valuable that insurance could be, perhaps there is hope of a quick, healthy, un-twist.

But, as the car salesman says, the big sale prices aren't going to be here forever.


  1. While I agree with the premise, it is hard to palate another tool for governments to run massive deficits into perpetuity with no intention of ever paying off the debt except with infalted dollars...

    1. I agree, it is a useful tactic if it would be done in conjunction with some spending cuts. But as it is now it just empowers further debt.

    2. Yes, I agree. But conditioned on all that, when bond markets wake up I'd rather see a fall in long term bond prices than inflation or default. It at least would give us some time to clean things up.

    3. I also agree but would just like to bring up the "why waste a crisis" argument. If we did refinance with the intent of buying more time to fix our fiscal problems would anyone in DC actually act to fix the problems? I personally don't think so.

      We can see in Europe all the concessions Germany has gotten from the troubled European states (whether those concession will or will not happen or not is a different topic). Professor Cochran, As a concerned tax payer I would appreciate it if you stopped giving government officials ideas to avoid tough choices (said jokingly I love this blog).

  2. You appear to be suffering cognitive dissonance between your theories and the evidence of the market.

    If interest rates are going to return to "normal" then "normal" is already priced in or the theories that you espouse are wrong.

    Personally I do not believe that normal interest rates are in the 5 to 6% range. Historically real risk free interest rates are more like 2% at the short end of the yield curve and 3 to 4% at the long end.

    The current very low interest rates may be because the market is predicting that the austerity policies now so widely promoted are going to destroy the world economy for decades to come.

    1. Your last sentence is doubtful. The markets are reacting to pandemonium in Europe, and an American Administration that doesn't know anything about economics and is hostile to commerce.

      Not sure what will happen in Europe, but you might be surprised at the pent up demand which will be released in this country when the regime is changed.

      As to interest rates, You are correct the long term prime is usually in the 3-4% range, but because western nations have been operating with an average of 2-3% inflation in the post war years you have to add that on to the prime.

    2. "an American Administration ... hostile to commerce."

      The idea that the Obama administration is hostile to commerce is ludicrous. They have handled Wall Street in particular with kid gloves when forceful intervention was called for.

      As a personal investor I shifted to cash because I concluded that the Republicans are hell bent on destroying the economy.

    3. Really? I invested heavily in gold when this regime went into operation because I had seen the things they were trying to do done in the 1970's. I will wager I made a hell of a lot more profit than you did in the last three years. (an average of 34% per anum)

      Yes Obama certainly has had his crony capitalists but that hardly negates the utterly negative and destructive tone and polices of his administration as a whole.

  3. You can no longer convince me that we would be in any way worse off if we fired Bernanke and the entire clown show at the Federal Reserve and went back to the gold standard. They clearly have no idea of what they are doing and no concept of trying not to gum things up. Letting economists run the banking system is like letting 14 year old boys run the bomb disposal unit. An explosion, and a nasty one that kills a large number of innocent bystanders, is not just highly probable, it is inevitable.

  4. "I will admit that understanding such low rates is stretching my rational-investor efficient-market prejudices"
    Scott Sumner: more Chicago than thou!

  5. Dr. Cochrane,

    Great post as always, if only anyone in Washington would listen.

    1) We should probably quote 11M (publicly held) as opposed to $15. You and I know entitlements are not getting better, but that is what we need to roll over as of now.

    2) Who is long on 30 years? The yields in the face of budget and future deficits defy logic. I highly doubt I'll ever believe anyone can be more efficient than the market, but newsless idiosyncratic stock moves and the 30 year have me befuddled. I worry the explanation is the treasury knows that the demand is low, has issued very few (hence the short US debt maturity) and what is issued is bought by the fed, strong armed banks (by the fed), or some insurance or pension legislation we have not thought through. Potentially even at 0% rates, 30 years due to silly regulation may not have 0 demand.

    3) To add to your point about the minimal value of a 15 bp drop in the 30 year ... how can someone argue that that marginal drop will do more to spur investment than eliminating the giant uncertainty (See John Taylor - First Principals) Washington has hanging over American businesses. A simple thought experiment. We're management of a large fortune 500 evaluating the NPV of a long-lived risky investment and plan to finance it exclusively via debt. Is the largest issue in calculating our NVP in our scenario analyses the cost of debt, or is it the fact we have no idea what the US regulatory, legal or economic structure will be like in 1 let alone 5 years. Is 15 bps off my debt holding me from green lighting the project? Or am I worried about a war in Iran or a US Cap and Trade bill doubling my energy costs; How to calculate the actual cost of health care for my employees over a long term; Europe, the ECB, and Dodd Frank doing nothing (negative really) to give me any confidence in money market and other short term lending markets leaving me terrified of any additional debt that could contribute to an overhang in case there is another run; needing a legal immigrant who happens to be the smartest person in his field to work on my project, I likely can't get him in the country; I am terrified that at any point in time in the future some smart lawyer can sue my business out of existence if anything goes wrong ... I am really stunned Dr. Taylor's advice has not been scooped up by either party.

    Sorry for being long winded. Brevity is on my long to-be-learnt list for graduate school.

    Thank you,


    2nd Year PhD Student
    Finance, McCombs Business School

  6. Did you know your site is blocked in china. I just came back from vacation and I could not get your site while there. I don't think it is because they don't like you. I think you might be using something in your website setup that just switched it off. I am pretty sure they like you, but your not getting through. They are big fans of Chicago in Fudan University, please recheck your settings in your website. Also. Please spread some dirt on people who don't embrace technology. We are going to have a real crisis soon because of professors not addressing the real issues facing our society. The implications of technology, and growth vs. Development. There seems to be some serious missunderstanding in this area in academentia.

    1. I'm almost flattered that they think I'm dangerous. Though free markets and political freedom are pretty well linked, as China is likely to discover soon.

      If anyone reading knows what settings might be unintentionally causing blockage, let me know. This is a pretty plain-vanilla blogger site.

  7. John, but the problem with your logic is that you are asking government bureaucrats to make a bet on the direction of the interest rates. Who says rates can't go lower ? 10yr yield in Japan is 0.82%. That's half of the 10yr rate in the US and Japan has twice the debt that we do and a WORSE trajectory for the debt than we do. Given this plain vanilla evidence, why do we need to make a bet now that rates will go higher? The reality is rates will go higher most likely if we have strong growth and not in any other scenario. And if we have strong growth, the budget situation will take care of itself.

    1. The argument is not a bet, it's a risk management issue. Buying fire insurance is not a bet that your house will burn down, really, it is paying a premium so that if it does burn down you won't be homeless. The case for a longer maturity structure survives if you think there are equal chances rates go up and go down. If they go down, yes, you paid a bit more to finance the debt. If a sovereign attack on US short-term debt breaks out, you're covered.

  8. Anna Schwartz died today. She and Milton both had unusually long lives. Maybe being a Monetarist is the key to longevity?

    1. I heard that she followed David F. And became an anarkist. Anarky is the reason she lived so long.

  9. i agree with 'IndependentVoter'...doesn't Japan scarily show that US can sustain this senseless money printing for a very long time?

    For 2 decades, Japan has done all the wrong things that US is doing now. Economy has suffered but, absent inflation, politicians manage to keep rates low.

    Its probably due to the falling 'velocity of money' which unfortunately has lot more room to fall.

    Is that right?

  10. This comment has been removed by the author.

  11. We have been advocating the change to longer maturity US debt for months now even though we acknowledge the useless attempt by the Fed to keep rates down for economic reasons, which we agree, are politically suspicious.

    As to your question of who in their right mind is investing in T's at 1.50% - which we suspect is partly rhetorical - the answer is "nobody". That is, this are not "investors" but sovereign entities trying to park their assets temporarily until the storm passes.

    This means that the Obama administration is in a pickle; to win the election they must get a substantial improvement in US economic conditions, and for such conditions to arrive the European Debt crisis must unequivocally subside and improve. But if the European crisis goes away (unlikely) in the next 3 months, the so called "investors" of Treasuries will sell (take back their money) and compound those likely domestic sellers that will try to avoid the radical capital gains increases coming January 1st.
    This double action will burst the Treasury bubble and cause an stampede from Treasuries bringing a major increase in interest rates, with all that it means for the deficits.

    The Fed is setting up a catch-22 that will hurt his boss.


  13. Good article, but one quibble. You wrote:

    The Treasury is trying, a bit. But the Fed is undoing what the Treasury is trying with "twist."

    Although this is the general perception, it may not be true. The average maturity of the debt is increasing, but it's not necessarily because the Treasury is trying. In fact, the debt has a built-in tendency to lengthen. This sounds odd, but the portfolio is so front-loaded that the ongoing expiration of maturing securities (which are very short-term just before they mature) drives up the average maturity, just as throwing off ballast causes a hot air balloon to rise. The Treasury is actually selling very short securities. The average life of its May issuance was less than half that of the whole portfolio. It is selling few long maturities.

    The Treasury is not actively lengthening the debt, and it is not undermining the Fed.

    I discussed this in a recent presentation to the Global Association of Risk Professionals. The slides and a summary can be found at:


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.