Comments by Daniel W: Greenspan's "conundrum"

Daniel W. commented:

""with due respect, i think the inflationists need to explain, convincingly, the action of the long bond. it is hard to accept greenspan's explanation of shortcovering by those who expected his widely pre-announced tightening campaign to produce the results history records. that may have had something to do with it, but the bond market is just TOO large to have had such a long and deep reaction. "

"also, the monetary aggregates are showing serious deterioration and suggest the beginning of an uncontrollable implosion. i hope this excellent site develops into a forum which fosters debate on these important matters and not just a trafalgar square soap box for one view. ""

Daniel, thanks for commenting at this site on several occasions. :) Blogs generally are part diary, part ego billboard, but you ask an interesting question about Greenspan's long bond "conundrum", and I'll give you my soap box opinion . 

Actually, as you know, a conundrum is a mystifiying event or question which is answered by or in a riddle. So what is Greenspan doing with this issue in this way? I owe part of my analysis, or at least the impetus to analyze, to two bearish analysts: John Hussman and George Slezak.

Hussman suggested that part of the pressure to buy bonds in quantity is coming from holders of pre-packaged mortgages who are suffering  from "duration gap" as mortgages in nearly all prior packages have been and are being pre-paid. The mortgages were bought as long term investments in a stream of income, but as these long term mortgages are refinanced--with the old mortgages paid off--the mortgage holders, who planned their own funding needs based upon coupon yield AND length in time, are being left stranded. Note that this is not an "at the margin" effect on new mortgage packages but affects each and every mortgage held from the past which gets refinanced. It's an on-going cumulative effect. The holders are thus faced with the urgent need to replace the yield and duration as best they can as rates fall. Thus it is very nearly a buying panic as they buy long duration treasuries to bridge the duration and coupon gaps.

Now we come to Greenspan's riddle: Remarks by Chairman Alan Greenspan
Central Bank panel discussion
To the International Monetary Conference, Beijing, People’s Republic of China (via satellite)
June 6, 2005

Here are a few excerpts:

"The pronounced decline in U.S. Treasury long-term interest rates over the past year despite a 200-basis-point increase in our federal funds rate is clearly without recent precedent. "

"A number of hypotheses have been offered as explanations of this remarkable worldwide environment of low long-term interest rates."

"One prominent hypothesis is that the markets are signaling economic weakness. This is certainly a credible notion. "

Then he talks about three other possible hypotheses. The second has to do with pension funding demands for future retirees, and he rejects this as not sufficiently robust. The third is bond buying by Central Banks. This he doesn't reject but finds the reality "modest" and "implausible" in the current environment.

Likewise number four:

"A final hypothesis takes as its starting point the breakup of the Soviet Union and the integration of China and India into the global trading market, developments that have permitted more of the world's lower-cost productive capacity to be tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of cost-reducing investments."

Thus of four hypotheses which have been  bruited about, he finds only the first, economic weakness "plausible", but doesn't endorse it.

Later in the week: Testimony of Chairman Alan Greenspan
The economic outlook
Before the Joint Economic Committee, U.S. Congress
June 9, 2005

After introductory remarks on the general economy he once again turns to the "conundrum":

"Among the biggest surprises of the past year has been the pronounced decline in long-term interest rates on U.S. Treasury securities despite a 2-percentage-point increase in the federal funds rate. This is clearly without recent precedent. The yield on ten-year Treasury notes, currently at about 4 percent, is 80 basis points less than its level of a year ago. Moreover, even after the recent backup in credit risk spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasuries over the same period."

Note that he tempers the "plausible" but not endorsed  hypothesis of ecnomic slowing by mentioning that "yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasuries over the same period." If economic weakness were the ghost in the attic scaring the treasury market, less than investment grade long duration bond yields would not be  dropping this much.

After repeating the conundrum for the Congressmen, he launches into the riddle:

"That said, there can be little doubt that exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding and home turnover, and especially in the steep climb in home prices. Although a "bubble" in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels."

"The housing market in the United States is quite heterogeneous, and it does not have the capacity to move excesses easily from one area to another. Instead, we have a collection of only loosely connected local markets. Thus, while investors can arbitrage the price of a commodity such as aluminum between Portland, Maine, and Portland, Oregon, they cannot do that with home prices because they cannot move the houses. As a consequence, unlike the behavior of commodity prices, which varies little from place to place, the behavior of home prices varies widely across the nation."

"The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace. "

A riddle tells you part of the solution, but only a part, and usually in a deceptive manner. Here Greenspan is telling us that falling rates induce mortgage refinancing and rising prices in houses, as well as in bonds. but don't worry because the housing market, at least for owner-occupied homes, isn't homogeneous or fungible since owners can't move their inexpensive Portland Maine  home to dearer Portland Maine to sell it.

What Greenspan is hiding in the riddle is that the FED has caused the "bond-carry" bull market in bonds by excessively low short rates, and now  there is a rush to be the last man into the carry trade  while there is still a spread and before the yield curve inverts. What else Greenspan is hiding is that the mortgage refinancing binge is precipitating a mortgage holders' duration gap buying panic as we saw above.

In the process he has identified several scapegoats--definitely not including himself or other Central Bankers:  hedge funds and second home buyer/flippers. He implies that none of this is the fault of banks, for whom he works, but rather of hot money. Since Greenspan is already into lame duck and swan song mode with retirement looming at year's end, he is pre-writing his excuses why something went wrong after he leaves.  He is also explaining why he must continue to raise short term rates with the dual risks of choking off economic activity or causing a mortgage and housing disaster.

Finally, his conundrum and riddle also reinforce his reputation as a victorious inflation fighter. Every time he speaks he downplays  inflation, as if it were common knowledge that inflation is history, not the present. The reality is quite different , as everyone knows. By waiting too long and by being excessively cautious he now admits (in riddle form) that he underestimated how powerful the new demand inflation was and is, and how he stimulated it further through the bond-carry and mortage duration gap bond panic.

The conundrum and riddle are classic retirement "cover your ass" farewells. The riddle master caused the conumdrum. Inflation rules.