Bond Yields Primer: Recognizing the difference between price and value

When yields decline, bond prices increase. The fact that prices are increasing means that there is more demand for those bonds. In other words, people are buying more bonds than before. As more people buy, price pressure increases and therefore bond prices rise. The question then becomes why people buy: many buy because some underlying belief about the future – irrespective whether that underlying belief is grounded in sound analysis or not. Others buy because they are mandated by their institutions (e.g. bond funds, pension funds, FRB open market operations). When we focus on those buyers who have a negative view of future economic activity, they will de-risk their investment portfolios and move to more liquid and less risky investments, such as bonds. In other words, money is leaving some other non-bonds market and entering the bond market. As more money rushes in, bond prices rise and bond yields decline. The reserve is also true: when yields increase, bond prices decline. Price declines mean people are selling bonds and purchasing other assets because in their view they believe other assets are more attractive (this trade-off is what economists call Opportunity Cost).  

When we look at the recent trend in the Treasury bond market we see a general widening of spreads (i.e. difference) between longer tenor (i.e. maturity) bonds and shorter tenor bonds. For example, the difference between the 3-month yield vs. the 10-year yield stood at 0.84% on 12/31/20, and it is now (as of 2/19/21) at 1.3%. In this instance, the yield for the 10-year bond has been increasing (from 0.93% to 1.34%; bond prices declining) and the yield for the 3-month Note has been declining (from 0.09 to 0.04; prices increasing). In other words, people are selling the 10-year bond (or decreasing the rate of purchase) and buying the 3-month Note at a faster clip.  

The increase in yields means money is leaving the US Treasury market and going somewhere else. Some of it is going to the shorter end of the Treasury curve, and some of it is going to other financial markets. At this time and in this context, this dynamic is being perceived as positive for market participants who hold riskier assets. However, it can also mean that the increasing yields are representative of a rate of market malinvestment (i.e. bad decisions increasing). I think the case for the latter point is more appealing. Market reversals tend to be poignant and sudden. Caveat emptor.

Lender and Buyer of Last Resort

After the 2008-2009 Financial Crisis, it became fairly obvious that the FRB would be engaged in a more meaningful manner when another crisis would occur. Any doubt has been removed when we look at what happened at the outset of the 2020 Pandemic crisis. It is a fine distinction, albeit somewhat controversial at this point, that the economic distress that has been experienced since March 2020 has been the result of government policy and not the virus itself. In other words, had the various productive institutions of society – that is, those bearing the direct costs of policy decisions – been allowed to drive the health mitigation efforts perhaps the course taken would have been different. At this point, that counterfactual is purely an academic exercise. The present circumstances are what they are. That said, what this present crisis has brought to bear is the reality that the level of support to the markets by the FRB has been unprecedented, although not at all unforeseen. Below is a Table that highlights the various lending facilities initiated by the FRB, the markets impacted, and their amounts outstanding: close to $90 billion of support remains outstanding. If history is any guide, and the Japanese experience comes to mind, the market interventions in a future crisis by the FRB will continue to be more obvious and we will ultimately reach a point when it will effectively become the buyer of last resort for everything.

Source: Periodic Report: Update on Outstanding Lending Facilities

US Federal Reserve's Balance Sheet: A Monster

As evidenced from the Table below, from February 2020 to February 2021, the Federal Reserve’s balances sheet has increased by a staggering 80%, mainly driven by increases in its US Treasury and Agency MBS holdings. The FRB purchases these securities in the open market, thereby increasing the amount of liquidity (money) in the economy and concomitantly increasing the money supply. When it sells securities the FRB is draining liquidity from the economy, and therefore decreasing the money supply. The FRB’s balance sheet will continue to increase for the foreseeable future, as they have committed to purchasing monthly at least $80 billion of US Treasuries and $40 billion of Agency MBS.

In thousands of dollars. Source: Federal Reserve Bank of New York

Interest Cost on US Treasury Securities

Another perspective to get a sense of the US Government debt burden is to look at the interest cost side of the equation. Delving into the US Treasury Department’s Treasury Bulletin, we find some interesting data. We note (see table below) that the annual interest cost on US Treasury securities has been inching up since 2016. Interest costs as a percentage of total government receipts (that is to say, tax it collects), has gone from 13.16% in 2016 to 15.28% as of fiscal-year-end 2020 (which was on September 2020). The upward trend post-2016 was the combined result of an uptick in both debt issued and increases in interest rates. In 2020, however, although the amount of debt increased, the FRB’s action to lower interest rates provided a cushion by preventing interest costs from rising when compared to the previous year – in fact, costs declined.

In million of dollars. Source: December 2020 Treasury Bulletin; October Average Interest Rates on UST

Turning into the private market holdings of US Treasury debt (see Table below), we see that the lion share of the distribution of debt maturity is within the 0 – 5 year span, ranging from 69.74% to 75% of the total. Short-term refinancing poses a risk when it comes to the rolling over of debt: as debt reprices in a higher interest environment, interest costs will spike; and similarly there may be less investors willing to enter the market at the prevailing interest rate, and as such demand much higher rates. Costs can therefore spiral out of control fairly quick. In the case of the US, as it is evident from recent experience, the FRB will step in and purchase US Treasuries if excess supply exists. However, the FRB cannot indefinitely continue to do so, unless it “pays the price” by way of a currency depreciation – which in fact it is what has happened since 2Q2020 if one looks at the US Dollar Index (ticker: DXY).

In million of dollars. Source: December 2020 Treasury Bulletin 

Subtraction by Addition: Why Federal Borrowing Makes No Sense

Following up on my last post on Total Federal Debt, another angle to consider is its productive capacity. In other words, we would like to know exactly how much “bang for our buck” we are getting for each dollar we borrow. If borrowing does not generate value greater than the amount borrowed, then we must question the rationality of continuing to do so. For example, if we borrow $1,that means that I am hoping to achieve more than $1 in total output in order to make it palatable to borrow. If we borrow $1, which we then invest, and then observe that total output has declined by more than the amount we borrow, then it stands to reason that the productive capacity of debt is actually negative for us. In this last case, the more we borrow, the more we are sinking deeper in debt. This is exactly what has been happening in the US.

Just take a look at this graph of Total Public Debt to GDP, courtesy of the St. Louis FED Fred:

Source: https://fred.stlouisfed.org/series/GFDEGDQ188S

In particular consider the time period since 1992. During the Clinton Administration, it can be seen that borrowing was sustainable because as debt increased, GDP increased at a faster pace, thereby reducing the ratio. But post-2001, under what was supposed to be a conservative Administration of Bush, the trend reserved upward. But starting in 2Q2008 the Total Debt/GDP ratio has been on a steady upward trend. The trajectory is particularly stark, especially when compared to the previous years. And that trajectory in a longer term perspective, we can see that it has been deteriorating even more so recently. 4Q2015 was a pivotal time in that it marked the beginning of the marginal decline in debt utility. In other words, prior to 4Q2015 we see that each dollar of Federal Debt created more than one dollar of GPD. To take the example of 2Q2008, at that time the Total Debt/GDP ratio stood at 64, which meant that 64 cents of debt generated $1 of GDP. But in 4Q2015 it took $1.029 of Federal Debt to generate $1 of GDP. And as can be seen by the latest available figure for 3Q2020, the ratio stood at 127.279, which in other words says that it takes about $1.28 cents to generate $1 of GDP. 

As GDP improves in the subsequent quarter, we would expect the current elevated ratio to decline or somewhat stabilize. But if history is any guide, just as noted in 2008, there is reason to expect a new trajectory has been established.

Total Federal Debt: The Road to Perdition

Particular numbers or data do not matter in and of themselves. They must be taken in context with respect to the broader trend. One of these data relate to the Total Federal Public Debt, as published in FiscalData.Treasury.gov.

I looked at the Federal Debt at various points in time considering the last 4 US Presidents’ start and end date of their Administration: Bill Clinton (Jan 1993 – Jan 2001), George Bush (Jan 2001 – Jan 2009), Barak Obama (Jan 2009 – Jan 2017), and Donald Trump (Jan 2017 – Jan 2021). What becomes fairly obvious when looking at the data is that Total Federal Debt been on a deteriorating trend. Each President has fared worse than his predecessor, which is to say that all of them added to the Federal Debt and each one outdid the previous when we look deeper into the numbers.

As can be seen in the data analysis below, Bill Clinton added approximately $1.48 trillion to the federal debt. George Bush outdid Bill in adding about $4.9 trillion. Barack Obama added $9.3 trillion. And last but certainly not least, Donald Trump added $7.8 trillion. Now bear in mind that Donald Trump was President for only for 1 Term, so we have to take into account that fact when comparing these amounts versus the other Presidents who presided for 2 Terms. When we take the total additions to the Federal debt and then divide it by the number of days each President was in Office, we can then see the daily average of total debt that was added. And by this last metric, Donald Trump has been by far the worse. The daily average of total federal debt for Clinton was about $506 million; Bush was about $1.7 billion; Obama was about $3.1 billion; and Trump was about $5.3 billion. 

The amounts are staggering. One can only reasonably conclude that the Biden Administration will likely dethrone Trump in breaking the daily debt accumulation record. My expectation is that the new Administration will likely add to the federal debt about $7 to $9 billion on average daily, which means that the total federal debt by the time the next President is inaugurated will be about $38 trillion to $40 trillion. 

The trend is ominous. The trend is catastrophic. Prepare accordingly. 

Data Analysis:

Smoke and Mirrors: Unemployment Statistics

The chart below comes via http://www.chartoftheday.com/20100903.htm?T. As the commentary notes, "the current job market has suffered losses that are more than triple as much as what occurs at the lows of the average recession/job loss cycle. Also, today's decline in jobs provides further evidence that the current 'economic recovery' remains sluggish at best."


There is nothing apart from political rhetoric and wishful economic thinking that contradicts this evidence. Few people truly recognize the futility of the economic "stimulus" for the sham that it was; this also includes all the policies enacted by the Federal Reserve Board. Unless a radical shift occurs in monetary and fiscal policies, the end result will be disastrous.