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Strange logic from Krugman

I’ve been getting questions about what happens when the Fed wraps up QE2 — related especially to Bill Gross’s public view that interest rates will shoot up.

OK. Gross has famously sold his entire Treasuries holding and is in fact short them. He is positioned for a fall in Treasury prices.

If you believe that it is obvious that rates will spike as soon as QE2 ends, you have to ask why investors aren’t moving out of US debt now in anticipation; you don’t have to believe in efficient markets to believe that totally obvious gains or losses will be anticipated.

I\’m sorry? We\’re using the fact that the man running the world\’s largest private sector bond fund has moved out of Treasuries in anticipation as evidence that people aren\’t moving out of Treasuries in anticipation?

Clearly I\’m not bright enough to gain a Nobel.

Also, if you think that US interest rates are being held down by the fact that in some sense the Treasury hasn’t had to go to the market lately, since the Fed is buying debt — although the Fed isn’t actually buying it direct from Treasury — consider the case of Greeece. Greece isn’t going to the market at all these days, since it’s getting all its funding from the bailout package.

Rilly?

The bailed-out nation sold €1.625bn (£1.43bn) of 13-week government bonds on Tuesday, but investors demanded a yield, or return, of 4.1pc to hold the debt – a quarter of a percentage point more than in a similar sale in February.

That means Greece pays a higher rate to borrow for three months than Germany pays for three decades, at 3.8pc.

11 thoughts on “Strange logic from Krugman”

  1. I think his point is that while one investor has indeed bailed out of US treasuries, not enough investors have done so to cause any meaningful increase in yields. Or rather – if they have there is a “market maker” there in the guise of the federal reserve to prevent sales becoming fire sales.

  2. Of course, the US could take advantage of an interest spike to redeem some of its debts cheaply. But that would require them running a surplus which isn’t ever going to happen, and that in itself would prevent a market-driven interest rate spike. It’s all academic anyway while you still have the central bank lending limitless funds to banks at low rates – that puts a lid on treasury yields. So inflation is the likely way out – commodities and equity will be safe, bonds (whether government or commercial) will not. Relatively speaking.

  3. Or rather – if they have there is a “market maker” there in the guise of the federal reserve to prevent sales becoming fire sales.

    I really do have troubling following some of this macro economics stuff.

    This sounds to me like a company in trouble telling its marketing department to buy its widgets from its sales department and then claiming to shareholders that all is well.

  4. I really do have troubling following some of this macro economics stuff.

    I have the same problem. Ultimately, it is because they have the ability to create money out of thin air to pay for it.

    Any normal company tries that and you go to jail for false accounting and/or forgery.

  5. SimonF, at least one Irish bank pulled that very trick – lending money to its chums to buy its own shares with.

    In the case of US government debt, because the federal reserve is creating demand that wouldn’t otherwise exist, the price is higher than it would be in a free market. That means the return from owning these debts (effectively, the interest rate on government borrowing) is lower than it would be in a free market. And since government debt is considered a bulletproof investment, the federal reserve is happy to create yet more demand by lending to the banks at a very low rate and see this money further loaned on to the US government (through buying its bonds) and using that as collateral on the loan. As I said, lending money to your chums to prop up your own share price.

    Really, none of us have an interest in seeing US government debt collapse in value, but that is what will happen, not only to the US but to Greece, Portugal, and anyone else, until these governments start making profits like everyone else has to to survive.

  6. Isn’t PIMCO out of treasuries as well?
    Translation from the Krugman:
    If you blow enough hot air into a lead balloon…

  7. “We’re using the fact that the man running the world’s largest private sector bond fund has moved out of Treasuries in anticipation as evidence that people aren’t moving out of Treasuries in anticipation?”

    No. Assume rates will spike as soon as QE2 ends. Since the market knows that this will happen, it will price for it, and the spike will occur now.

  8. Emma Rowley misunderstands bond yields. Germany cannot borrow for three decades at 3.8%, that’s a per year rate.

    The only way Krugman could be wrong is if enough buyers – the Fed isn’t big enough I think – don’t really care about the future yield. This might be the case given foreign central bank buying and perhaps legally obliged institutional buying (is that the case in the US as the UK?). But the market is very large and liquid, and I don’t think the facts really support your argument.

  9. “The only way Krugman could be wrong is if enough buyers – the Fed isn’t big enough I think – don’t really care about the future yield.”

    The Fed has the largest holding of Treasuries. So i think it probably is big enough to have a distorting effect on the market.

    “No. Assume rates will spike as soon as QE2 ends. Since the market knows that this will happen, it will price for it, and the spike will occur now.”

    But investors doesn’t know for sure that QE-2 will end in June. And the Fed will still be buying at least half the new issuance until June, which will rather curtails the chances of rising yields.

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