Guest post: is there a bubble on the bond market?

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By John Y Campbell, Adi Sunderam, and Luis M Viceira, first posted at VoxEU

The historically low yields on Treasury bonds are the hallmark of a bubble, according to some commentators. This column analyses the relationship between bond yields, the stock market, and inflation over the past 50 years. It finds that the riskiness of nominal bonds changes over time and that investors and policymakers can use the changing stock-bond correlation as a real-time measure of inflation expectations.

The yields on government bonds are at their lowest levels since the depths of the financial crisis in late 2008. On Monday 18 October, the yield on 10-year Treasury notes hit 2.52%, down from 3.85% at the beginning of the year. This movement is huge by the standards of the Treasury market. An investment in 10-year Treasury notes has returned about 11.4% this year.

Moreover, nominal bonds are exposed to inflation risk. Given that the use of unconventional monetary policy has increased uncertainty about inflation (e.g. Taylor 2009), one might expect investors to regard bonds as particularly risky and demand high yields (low prices). The persistence of historically low yields in the face of such risks has led some commentators, notably Siegel and Schwarz (2010), to suggest there is a bubble in the government bond market.

Bond valuation and risk

What determines how much investors are willing to pay for nominal bonds? There are three critical factors:

* expected inflation,
* real interest rates, and
* risk premia.

Since inflation erodes the real value of the payments bond investors receive, they must adjust prices for expected inflation to earn their target real interest rate. In addition, bonds are risky because realised inflation and interest rates can turn out to be different than investors’ expectations. Risk premia are compensation for bearing this risk.

In recent work, we examine how the riskiness of bonds varies over time (Viceira 2010; Campbell et al. 2009). In particular, we argue that inflation makes bonds risky at certain times, while giving them insurance, or hedge, value at others. For instance, if inflation rises unexpectedly when economic conditions deteriorate, the real value of bond payments falls unexpectedly. In this case, bond investors sustain losses when they likely need funds, and bonds are risky assets that investors should charge a risk premium for holding.

In contrast, if inflation falls unexpectedly when economic conditions deteriorate, bonds are like insurance, providing a windfall at the time investors need it the most. Bond investors should be willing to pay for this insurance value, just as they are willing to pay for other types of insurance. In this case, the inflation risk premium should actually be negative.
Historical evidence

The idea that the riskiness of nominal bonds changes over time is consistent with the evolution of conventional wisdom among investors. In the late 1970s and early 1980s, investors regarded bonds as risky. The famous bear Henry Kaufman, also known as “Dr. Doom”, argued that investors should completely avoid bonds unless they offered high risk premia. In contrast, by the early 2000s investors had come to regard bonds as a safe haven against the risk of a Japan-style episode of deflation.

This conventional wisdom is broadly consistent with the lessons of financial economics. In particular, the Capital Asset Pricing Model (CAPM) uses the stock market as a proxy for economic conditions. This suggests a simple metric for the riskiness of an asset: how its returns co-move with stock market returns. Risky assets do poorly at the same time the stock market does poorly, causing investors to sustain losses at the worst possible moment. Such assets should have large risk premia to compensate investors for this risk. In contrast, safe assets do well when the stock market does poorly, adding insurance or hedge value to investor portfolios. These assets require small or even negative risk premia.

Figure 1. Stock and bond returns over time

Figure 1 plots the co-movement of stock and bond returns over time. The intuitions of the CAPM are broadly consistent with the way investors have historically viewed bonds. In the late 1970s and 1980s, stock and bond returns co-moved positively. When stocks did poorly bonds also did poorly, consistent with the idea that they were risky. By the 2000s, stock and bond returns co-moved negatively, suggesting that bonds had become safe havens.

Figure 2. Bond returns and inflation over time

Figure 2 shows that the behaviour of bond returns is related to the behaviour of inflation by plotting the historical co-movement of stock returns and inflation. Since inflation is bad for bond returns we invert the graph. The pattern is very similar to the co-movement of bond returns and stock returns: positive in the 1970s and 1980s and negative in the 2000s.

Thus, it appears that the changing risks of nominal bonds are related to the changing relationship between inflation and economic growth. When inflation is procyclical, as it was in the 1960s and 2000s, inflation falls at the same time that unemployment is rising and growth is falling. During these periods, stocks and nominal bonds are negatively correlated and nominal bonds hedge deflation risk. In contrast, when inflation is countercyclical, as it was in the 1970s and 1980s, inflation rises as unemployment rises and growth falls. In an environment of stagflation, stocks and nominal bonds are positively correlated and nominal bonds are risky.

Implications for the current environment

What can this model for bond prices tell us about the world today? Figure 3 shows the co-movement of stock and bond returns, our measure of riskiness, over the last five years. The series turned sharply negative once the financial crisis began in mid-2007, briefly returned towards zero by mid-2009, and has again been quite negative over the past year.

Figure 3. Stock and bond returns and riskiness over time

The stock-bond correlation implies that investors currently view government bonds as a hedge against the possibility of deflation and low growth. Though they may be uncertain about the direction of inflation over the next five years, investors appear to believe that any increase in inflation will likely be accompanied by growth, making it less painful for their portfolios.

In evaluating the current level of bond prices, the critical question is whether investors are correct. If inflation will indeed be accompanied by growth, then nominal bonds should carry a negative inflation risk premium and correspondingly high prices. However, it is also possible that the economy could enter a period of stagflation with high inflation and low growth. In this case, investors should be charging a higher inflation risk premium, and bond prices should be lower today.

Our work also has important implications for policymakers trying to use financial data to understand inflation expectations. First, policymakers can use the stock-bond correlation as a “canary in the coalmine.” If the correlation starts to turn positive, policymakers will know that investor anxiety about stagflation is rising. They can then take steps to keep inflation expectations well-anchored.

Second, policymakers often use break-even inflation, the difference between the yields on nominal and inflation-indexed bonds (TIPS), as a proxy for market inflation expectations. However, this quantity is actually the sum of expected inflation and the inflation risk premium. Thus, if the inflation risk premium is negative, breakeven inflation understates market inflation expectations. The negative correlation between stocks and bonds today suggests that the inflation risk premium on Treasuries is negative, and it could be as low as -75 or -85 basis points. This implies that investor expectations of 10-year inflation reflected in the bond market are around 2.7%, in line with the view of professional forecasters and the inflation swap market.

Conclusions

Financial market data suggest that investors expect inflation to be moderate and procyclical going forward. However, the behaviour of inflation has changed in the past and may do so again. Investors and policymakers alike can use the stock-bond correlation as a real-time measure of inflation expectations.

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Guest post: Gulf Oil Spill... mission accomplished or ongoing crisis?

Guest post: Gulf Oil Spill... mission accomplished or ongoing crisis?

→ Washington Blog

Media companies have stopped almost entirely covering the Gulf oil spill.

Many tried to say that the effects of the spill are far from being as bad as feared, and everything what is fairly well cleaned place and back to normal.

But today, it is generally reported that there is currently massive extends weathered petroleum spotted in the Gulf of the Mexico.

And as Oil Spill Law (FOSL) Florida websites tirelessly reported on the Gulf oil spill this all the time.

To give an example of the crisis underway in the Gulf, this is a gathering of some of the stories high top FOSL 3 days:

In related news, Government - always willing to go immediately to the bottom of what is happening really about and know perfectly the results - then sent crucial Gulf samples for analysis in a laboratory... Poland (u.s. laboratories are apparently occupied test toxicity hinky, mortgage mortgage saved titles, app and CDS naked) .and the result will be shipped by slow boat: NOAA does not wait for results back to the end of the year.

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Guest post: 5 myths about rape - and how they relate to TARP

Guest post: 5 myths about rape - and how they relate to TARP

By reader Jackrabbit, hoisted from comments on "Tim Geithner Magical Mystery Tour of propaganda TARP A Little use truth":

1. If you say 'no' is not rape

TARP was presented as the way of just to avoid a magma bas.Le rapist used a firearm. A more thoughtful approach would at least extracts some concessions from banks and provided some responsibility in exchange for the bailout.

Provided 2 it about yourself (you flirted, did not hide, did not take precautions, etc.)

Is wages have stagnated over the past two decades.People are turning to credit relief and responded to what appeared to be a good portion (the possibility of accessing the property).

3 If alcohol or other drugs have been consumed, you have no case

Of the financial services industry shrills tell us again and again that Americans have been drugged credit and industry was maintaining fair to their customers.This is poppycock.Le financial sector pushed credit relentlessly and regulators let without regard for the consequences (because they have been caught) .the FBI warned of fraud in the subprime market years before TARP, but nothing is done about it.

4. Your past indiscretions will be used against you

Americans have been complacent and politically apathiques.Ils allowed policy be overtaken by interests financiers.Certains say, "you get the Government you deserve."That excuse the fact that public confidence has been raped.

5 What is done is done, its best simply forget and move

Accept the unacceptable (we were all responsible for the financial crisis - TARP was a success that cost little and reflecting on our stewardship of Governments, the economy) personally is destructive and reinforces the authors.

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Guest post: so why mortgage services use "Robo signatories?

I received an email from a correspondent, I'll call MBSGuy and I thought that readers will find instructive. He has been an expert witness in a few cases of securitization (which is an area with relatively little jurisprudence, unlike real estate). And where it is not obvious, to serve as an expert witness, you know what you're talking about.

By MBSGuy:

I think that the calculated risk is a great site and I have read all the jours.Mais essentially CR has avoided mortgage securitization market details. It was really the Tanta grass.

"" CR has a post up until now, which is a troubling, as he mentions "hysteria" and "disinformation" interpretation of critical issues .the ' article "why Mortgage Servicers used"robo-signatories"?"Although well-intentioned, replied to the question posed in the title and adds no actual information is about two weeks delay.

It is manifestly incorrect to say that the question of the "lock the door" is on "robot-signatories. A dozen top banks page or voluntarily suspended repairers locking in a large part of the country because the title insurers have stopped working at ease on their sales of locking, borrowers have had increasing success challenging seizures, their subcontractors (such as plant foreclosure and lender processing services various firms) have been studied for fraud and perjury and new began to emerge were much more widespread problems that had been previously reported.

The legal structure of foreclosure was canceled. Robo-signatories were just a manifestation of a much larger issue that was already becoming a problem.

People who believe that the issue of locking the crisis is precisely maintenance are new to the issue or refuse a few obvious questions about what was going on.Certainly all aspects of the labour intensive process may be exposed to human error and errors, but you might think errors could be distributed randomly instead of concentrates in the same parties, the same documents over and over again in the same way.

I think that a reasonable examination of the facts shows that the documents have been prepared properly because of an error, but rather due to a strategic choice.

How can you investigate this issue in detail and not wonder why repairers have chosen roads they have?If it was really a whole bunch of technical errors, how they have never done anything to solve the problem, even if they were confronted with a legal challenge to a growing number of borrowers?

No doubt someone engineer knew that present unverified affidavits could create legal problems deposition of GMAC Jeffrey Stephan, who seemed to break the case opened in September, Mr robot actually 2009.GMAC on notice of the problem with the unverified affidavits for over a year and has nothing - in fact, they have supported thousands more with the same problems, even after Mr. Stephan admitted before the Court that he argued repeatedly false statements under oath in court b.c ' is their business to present on a basis not verified it was not a technical error.

After attending an engineer and his counsel lie several times before a tribunal where I testify, I can say with certainty that the misrepresentations were not erreurs.Je wondering why they spent so much money in dispute our assertion that shape note and mortgage were not how it.If engineer had simply made a mistake, why did they will only correct and submit locking on behalf of the Party really holding title to (rather than the people that they wanted to hold the title)?

They submitted documents to cover errors earlier in the process of mounting u.s. ' it is true that maintenance "mistakes" are correlated to the number of loans with problems of transport, and then it appears that the problem of transport can be large enough.

In fact, the hysteria appears to be from people as CR and repairers themselves .Ne preventively and voluntarily stop locking in 23 or 50 States look a little to produce an overreaction if it was really a few technical errors in the preparation of some otherwise uncontested maintenance documents?

Refusing to ask "Why repairers prepare as many incorrect documents?" is evidence of a very advanced stage of denial.

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Guest post: Foreclosure counterattack - propaganda, brutality and Pseudo-Legality

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By Russ, aka Attempter, a sustainability activist trying to help figure out solutions to America’s crisis, who blogs at Volatility

As Foreclosuregate, the legal crisis, looms ever larger and becomes a major political issue, the banks and government have scrambled to mount a counteroffensive against the consequences of their crimes. We can see how flat-footed they were caught. They seem to have become so comfortable with cutting every legal corner and evading every requirement which was even mildly inconvenient that they’re truly surprised this has escalated with such abruptness and violence. Their plan is to try to bluster and bully their way through by any means possible. They expect lies and lawlessness to prevail as always.

The first line of defense is the propaganda line that this is just a technical glitch, not a fundamental problem with the loan or the security, or any kind of systematic intentional fraud. So far this has been the preferred PR line for the administration and the mainstream media. But the banks are also working the line that no matter what the flaw, it can simply be legalized by legislative brute force.

Rather than deal with the considerable consequences of these abuses, the banks are prepared to bulldoze well settled state laws to give them an easy way out. And I’m not basing my view on this story alone; I had a conversation yesterday with a Congressional staffer who matter-of-factly said (but with little understanding of the underlying issues) that Congress would intervene on behalf of the industry, via its authority over national banks.

Congress took one step in this direction by frantically grabbing and unanimously passing a pre-existing bill which would require all states to accept the weakest state-authorized electronic notarizations. This would be only a minor fix of one of the technical issues, and isn’t very important in itself. But it probably foreshadows the far more expansive legislation we can expect to see after the election. Bolstering all of this, the banks are making extortionate threats against the real economy. They promise to wreck it even further if they aren’t given a clear path on this.

At the same time a concurrent propaganda line, seeming to somewhat contradict the other, is a hectic emphasis on speed.

Federal regulators sought Wednesday to prevent the growing furor over improper foreclosures from escalating, pressing mortgage lenders to replace flawed and fraudulent court documents while insisting that foreclosures continue apace.

It’s unclear why they’re simultaneously trying to downplay the significance of all this but also to drum up a sense of crisis which requires a stampede. You’d think they’d at least pretend to want to slow things down in order to make sure all those alleged “technical glitches” are properly fixed.

Demonstrating that the banks understand the significance of how the blogosphere has driven this story, the PR offensive has descended to the comment thread level, as we’re seeing the biggest surge yet of pro-bank commenters, many repeating the same talking points with suspicious discipline.

As Yves Smith at Naked Capitalism observed,

One regular reader has noticed that every time I put up a foreclosure post, the first comment, suspiciously close to the post time, is always a version of “deadbeat borrower”. He reads enough blogs that he is pretty convinced that NC is being targeted for this sort of message.

Perhaps the most insidious propaganda line, and certainly the most scabrous, is the bashing of alleged “deadbeats”. While the subprime borrower – powerless, often a minority – has long been an easy target, and the contempt has been spreading up the income scale as more people are engulfed in the catastrophe, the fact remains that few people intentionally bought more house than they could afford. Most were induced by the massive propaganda barrage from the banks, government, MSM, and even consumer groups, to see a house as a guaranteed investment which could only appreciate in price. More importantly, the main cause of inability to keep up the mortgage is losing one’s job or suffering a medical disaster. It’s the banks themselves who have presided over the destruction of America’s jobs, especially over the last two years. And it’s the government which refuses to counteract the banks’ campaign of socioeconomic scorched earth. (That’s the same government which also pointedly refused to reform the health care system, choosing instead to further entrench the existing larcenous dysfunction under a facade of lies and misdirection.)

So it’s the banks and government themselves who are overwhelmingly responsible for the wave of defaults. The defaults are the knock-on effects of the bank crimes, and now the banks want to seize the homes by further criminal means. Even after all this, few people fight foreclosures if they can’t afford to pay. The great majority of them say they can pay if they get a promised modification, or claim to be the victims of servicer error. So by any measure – moral, rational, or legal – the “deadbeat borrower” talking point is a sham.

But it’s no surprise, given the scurrilous character of the banks and their functionaries. A good indication of the kind of “legal” recourse they assume they can take are the kangaroo courts of Florida. These are not really courts of law but dedicated foreclosure machines manned by judges pulled out of retirement, apparently selected specifically for their bank-friendliness and/or ignorance of mortgage law and existing programs like the HAMP. These were given the mandate to process foreclosures as fast and lawlessly as possible. That puts the administration rhetoric about the need for speed in a new light. Evidently Florida’s rocket docket is the federal government’s dream solution as well.

But even this is failing to work for them. Political scrutiny and demands for legality are becoming more insistent, and the rocket docket has had to slow down and at least pretend to respect the law.

Underlying all of this, the foreclosures continue in spite of the vaunted moratoria. Perhaps they think they can still fool the judges this way: “We announced our moratorium, so obviously we’re only going ahead with fully legit foreclosures. Here’s the lost note affidavit on this one…” Now that this scam has been exposed, they’re spouting a reprise of the original lies – it’s a mistake, it’s miscommunication, we don’t know what’s happening with those bad apples….(Anyone who actually took anything they said seriously would have to wonder how it’s possible to be such a Master of the Universe, and warrant such a “bonus”, and yet make so many self-admitted mistakes and be so ignorant of everything all the time.)

This preference for lawlessness, this knee-jerk recourse to lies and crimes, is however no joke. At the lower levels, outside the regular media eye, the banks have repeatedly demonstrated their comfort with pure brutality. The examples proliferate of thugs threatening people, breaking and entering, bashing in doors, terrorizing occupants. So long as government at every level is the waterboy of the banks while people on the ground remain unorganized, atomized, and vulnerable, this will only get worse. We hear rhetoric, “joking” of course, about how they need to start burning houses down.

“The question to me is not do you foreclose or do you not foreclose. The question is when and with what philosophy you foreclose,” the man on the bank restructuring team said. “If you want to reduce the amount of leveraged homeowners you have, you need to ultimately kick them out of their homes.” A colleague walked up: His recommendation was to burn houses. It would lower the supply.

Even if that’s still a joke at the moment, how long can it remain so? It’s certainly in the mainstream of the logic.

Look, our hope is is that this moves rapidly and that this gets unwound very, very quickly and that if they can go back, reconstruct their paperwork and what we’ve stressed to them is that they need to expedite that process and work very, very quickly to get it done. we’re going to continue to push for that.

That’s Obama factotum Axelrod. And more from the firebugs:

“The first thing that needs to happen, I think, is to get these people out of their homes,” a man wearing a bespoke blue-striped shirt, a Hermés tie patterned with elephants and Ferragamo loafers said recently. “Correct! I’ll explain,” the veteran member of a bank restructuring and advisory team said.

Right here at Naked Capitalism we may have seen the pro-bank handiwork, a shot across the bow. Yves was the target of a Denial of Service attack. Now that’s taking trolling to a whole new level. If it was organized on behalf of the banks, it’s part of the logic.

All of this, from the original predatory lending, to flippancy about conveying the titles and legally securing the trusts, to the Bailout dedicated to propping up those toxic MBS, which we now know are probably nothing but unsecured loans, to the government-led propaganda campaign and legislative hankering to cover up and eventually “legalize” this latest revelation, down to the brutish violence and dirty tricks of the gutter, is one coherent whole, one simple train of logic. It’s simply the logic of might makes right, feudal greed, and total nihilism vis the law and democracy. The mortgage debacle reveals so many abdications of the system, and this abdication of the rule of law is one of the most thorough.

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