As previously confessed, I love unraveling paradoxes: finding the logic linking seemingly illogical strings of arguments. ¹ Fortunately, my night job as a practicing economist is a lush garden for studying paradoxes. And even more fortunately, I get to eat the fruits from that garden in my day job as a portfolio manager!

In evaluating both the economy and the financial markets, the most important paradox to understand is the “paradox of aggregation”: circumstances in which individually rational behavior can produce collectively irrational outcomes. Indeed, the paradox of aggregation is the bridge between micro economics, which examines the dynamics of individual markets, and macro economics, which examines the dynamics of a system of markets.

Adam Smith’s invisible hand rules microeconomics: at market clearing prices, supply and demand tautologically equal each other. In contrast, John Maynard Keynes’ paradox of thrift rules macroeconomics: the supply of savings and the demand for investment must equal each other after the fact; but a surge (contraction) in the collective desire to save will paradoxically reduce (increase) both the supply of savings and the demand for investment, because expectations of collective spending drive investment, which drives collective income .

In microeconomics, savings and investment can be either the horse or the cart. In macroeconomics, investment is the horse and savings is the cart.

The Fed is presently pleading with the horse to giddy up, holding a 1% Fed funds rate under his nose, promising to hold it there until pricing power is restored to tangible capital – to wit, inflation goes up. The Fed is also grateful that the U.S. fiscal authorities are lightening the load the horse must pull by dis-saving, otherwise known as running huge fiscal deficits.

We are indeed all Keynesians now, as Richard Nixon opined prematurely some thirty years ago. The Fed is printing twenties and Congress is borrowing twenties. And this is the way it should be, given that inflation is too low and unemployment – of both tangible and labor resources – is too high.

To be sure, it’s a G-1 Keynesian world, with the U.S. spending horse pulling the rest-of-world mercantile cart of savings, as represented by America’s huge capital account surplus. And much of the surplus (the mirror image of America’s current account deficit, of course) comes from the printing presses of foreign central banks, notably in Asia, as shown in the graph on the previous page.

I submit, however, that America is not addicted to foreign savings, notwithstanding the Calvinist preaching of many of my dear friends. Rather, foreign producers are addicted to American consumers. America does not depend on the kindness of strangers; foreign central banks’ funding of the American current account deficit is not an act of kindness, but an act of self-interest. In a G-1 Keynesian world, the American current account deficit is not a problem, but the firebreak protecting the global economy from Keynes’ paradox of thrift.

What the world needs, as I argued forcefully last fall, ² is an outbreak of G-3 Keynesian fever, a coalition of the willing running printing presses and fiscal deficits to support domestic demand, rather than to fund domestic demand in America. But alas, waiting for that appears to be akin to turning on the landing lights for Amelia Earhart. That said, a G-1 Keynesian world is better than a G-0 Keynesian world! America may have a current account deficit “problem,” but the global economy would have an even bigger problem if America didn’t have such a “problem.” Not all problems need to be solved.

To be sure, if the rest of the world all of a sudden got Keynesian religion, ginning up domestic demand, the U.S. current account deficit might be a “problem” – the dollar would tend to go down faster than otherwise would be the case (global reserve currencies are always in secular decline!), implying higher U.S. inflation that otherwise would be the case. Put differently, Americans would become relatively less rich – or relatively more poor, if you are a Calvinist! – than the trajectory under G-1 Keynesianism. For the good of global capitalism , however, such an outcome would be a high-quality “problem.”

But What About Bonds?
Investors in the U.S. fixed income market certainly wouldn’t feel this way, of course. Indeed, blatant, full-throated Keynesianism, even of the G-1-only strain, will likely lift the U.S. inflation rate. In fact, higher inflation will be the definition of Keynesian success. Reflation is as reflation does, in the words of Keynes’ protégé, Forrest Gump. Which brings me to what I really want to talk about this month: the paradox of a “rational” bubble in Treasuries.

I think U.S. Treasuries are currently in a bubble, because I believe that U.S. monetary and fiscal authorities will be successful in restoring pricing power to American business: higher inflation. I don’t, however, have the same degree of conviction about a current bubble in Treasuries as I did in late 1999 about a current bubble in stocks. ³ Back then, valuation for stocks simply could not be defended; no way, no how: the market-discounted growth rate for profits relative to nominal GDP growth implied that in the fullness of time, profits would equal GDP. Stocks were obviously infected with irrational exuberance.

I simply can’t say that about the Treasury market right now. It is in a bubble if, and only if , Keynesian reflation gets “traction.” If it doesn’t – to wit, I’m wrong! – then Treasuries are most certainly not in a bubble. To evaluate “fair value” for the Treasury market, I must consider (1) the probability that I’m wrong, (2) the probability that others might consider that I’m wrong (as per Keynes’ beauty pageant), and (3) the date and time of the eventual Keynesian reflationary victory.

Of these three factors, the first is most important in the longer run – say, the next 3-5 years. If Keynesian reflationary policies get traction, pushing up the core inflation rate (PCE deflator) by, say, 100 basis points, then 10-year Treasuries are probably destined to rise to 5-6% (assuming a Wicksellian “natural” real long-term interest rate of about 3%). In contrast, if Keynesian reflationary policies don’t get traction, or lose traction, then Treasuries yields are probably destined to fall to 1-2%.

If we put a 75% probability on the successful scenario and a 25% probability on the unsuccessful scenario, that implies “fair value” for the 10-year Treasury of 4-5%. The yield is less than that now, but by less than 50 basis points; and if we were to change the probabilities to 65% and 35%, the “fair value” range would fall by almost 50 basis points. So, while the Treasury market is clearly in a bubble if Keynesian reflationary policies “work,” there is no reason to expect the bubble to burst unless and until that presumption is proved to be correct. Thus, if the Treasury market is in a bubble, it is a “rational” bubble .

A Forward Curve On The Fed
Part of the “rationality” of the current Treasury market is, I submit, the likely course for Fed policy. While the concept of a “natural” real rate of interest is kicked about all the time in this business, it is a very loose construct. It’s kinda like talking about a river three feet deep on average; interesting if you want to calculate the volume of water that it holds, but not particularly germane if you don’t know how to swim.

In real time, there is nothing “natural” about the Treasury market (or more technically correct, its swap market brother), because a government-sanctioned monopolist, who owns a printing press for money, pegs the Fed funds rate – which is directly linked to the overnight financing rate for buying Treasuries on margin (the reverse repo rate). Thus, the yield curve for Treasuries is actually a forward curve for the Fed-pegged Fed funds rate, plus a risk premium .

To be sure, the Treasury market is also influenced by what is known as “segmented markets” demand, most significantly (1) buyers of longer-duration instruments who need them to “match” longer-duration liabilities (thereby stabilizing the net present value of their net worth); and (2) foreign central banks (redeploying dollar receipts generated by their mercantile foreign exchange policies). These buyers (and sometimes sellers) do what they do with only limited regard to forward expectations of the Fed funds rate.

In cyclical time, however, “opportunistic” buyers and sellers of duration – un-levered ones like PIMCO, trying to beat market indexes, and levered ones such as dealers and hedge funds, targeting absolute returns – set the course for the Treasury market, not foreign central banks and/or buy-and-hold duration buyers. And expectations of Fed policy are the straw that stirs their opportunistic drink, dominating the influence of “natural” duration buyers on the level and slope of the Treasury yield curve.

Thus, while a structural “fair-value” framework for the Treasury market, founded on the notion of a “natural” real interest rate (per Wicksell) plus inflation (per Fisher) is useful, such a framework must, for active portfolio management purposes, be combined with:

• a forecast of where the Fed is going to peg the Fed funds rate; and
  
  
• a forecast of where market participants are, collectively, going to set the risk premium for uncertainty about where the Fed is going to peg the Fed funds rate (and the risk premium for the inherent price volatility of longer-dated instruments).

The Fed Goes Anti-Deflation
If there was ever any question about this dynamic dance between the Fed and opportunistic buyers/sellers of duration , market action since last November, when the Fed launched a rhetorical anti-deflation campaign, should end it. Regrettably, Fed Chairman Greenspan started the campaign on November 13 by declaring that the Fed could/might buy longer-duration Treasuries outright:

“There is an implication in the notion (of fighting deflation risks) that we are restricted solely to overnight funds. But our history as an institution indicates that there have been innumerable occasions when we have moved out from short-term assets and invested in long-term Treasuries. We do have the capability, if required to do so, to go well beyond activities related to short-term rates.”

I say that it was “regrettable” that Mr. Greenspan started the anti-deflation campaign this way, because he needlessly changed the nature of how Treasury markets participants must handicap prospective Fed policy. Outright buying of long-term Treasuries was and is a “last resort” for the Fed, and a step that is highly unlikely to ever be taken. The Fed would/will do so if, and only if , market participants fail to appreciate and discount what the Fed was planning to do, and is planning to do: hold the Fed funds rate super low for a long, long time.

Fortunately, Fed Governor Ben Bernanke clarified matters a week after Chairman Greenspan spoke, declaring on November 21:

“So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure – that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time – if it were credible – would induce a decline in longer-term rates.”

“A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.”

Mr. Bernanke’s statement was a huge improvement on Mr. Greenspan’s comments, in that Mr. Bernanke explicitly introduced up front a “pre-commitment strategy” of holding down the Fed funds rate as a quite logical step, “ if credible ,” to inducing a decline in longer-term rates. But he also declared that he “personally preferred” a more direct approach, including a pre-commitment to outright buying of Treasuries out to two years maturity to “enforce” announced explicit ceilings. Thus, in my view, Mr. Bernanke left too much ambiguity on the table about the Fed’s intentions.

Thankfully, FOMC Secretary Vince Reinhart, on March 25, 2003 lifted this ambiguity (at least for me!), describing outright Fed buying of longer-dated Treasuries (for the purpose of manipulating their yields, rather than in routine reserve-creating operations) as a back-stop to a “pre-commitment strategy” of holding down the Fed funds rate (my emphasis):

“The yield curve has two components, the discounted expectations of future short-term interest rates and term premiums. As to the former, the Federal Reserve could attempt to influence expectations by being explicit as to the duration it would hold overnight rates at a low level. By credibly extending the length of its commitment, it could induce long-term rates to fall. This could be communicated to the public either through an explicit promise of holding the funds rate at a low level for a fixed length of time or until some macroeconomic intermediate target is achieved, such as the cessation of declining prices. That promise could be made more concrete by operating in the forward interest rate market or writing options that would make it costly for the central bank to raise rates for a preset period of time.”

“If asset prices do not adjust sufficiently to stimulate spending, then open market purchases of longer-term Treasuries, in sizable quantities if necessary, can move term premiums lower. Of course, such a promise to put a ceiling on parts of the yield curve would be reinforced if it were associated with a credible promise to keep the short rate along a path consistent with those long-term rates.”

Theory Morphs Into Reality
At the May 6, 2003 FOMC meeting, the Fed took its first step in a “pre-commitment strategy” of holding down the Fed funds rate, declaring that (again, my emphasis):

“Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level . The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.”

You could have peeled me off the ceiling of joy when I read that statement: Glory be, the Fed has finally – finally! – declared victory in its since-1979 secular war against inflation. The Fed was “neutral” in its risk assessment about growth, but was tilted to worry about unwelcome downside risk on inflation and, accordingly, was biased to cutting/holding down the Fed funds rate. Fixed income market players immediately broke the Fed’s “pre-commitment strategy” code, and just as Ben and Vince had predicted, drove longer-term Treasury rates sharply lower, as the market ratcheted down forward expectations of Fed-controlled short-term rates, as shown in the graph below.

For reasons that still perplex me, however, many market players also started thinking that the Fed’s next step, to appear soon, would be outright buying of longer-term Treasuries, in an explicit effort to drive down their yields. To me this never made sense, as discussed last month ⁴. What did make sense was to expect that at its June 25th FOMC meeting, the Fed would (1) cut the Fed funds rate by 50 basis points, to “validate” the sharp market-driven decline in longer-term rates, while (2) providing more detail about its implicit target of a higher inflation rate, so as to provide a “firebreak” – Mr. Greenspan’s word in a June 3 speech – from deflationary risk.

In the event, the FOMC did neither, cutting the Fed funds rate only 25 basis points, while declining to “build out” (as PIMCO account managers say!) the case for a “firebreak” of somewhat higher inflation, putting parameters/conditions on just how long it was willing to hold the Fed funds rate at the new lower 1% peg.

But all was not lost, even though the Treasury market reacted violently, pushing rates up “out the curve” in response. The FOMC took an additional small step in defining the “pre-commitment strategy” to holding down the Fed funds rate. Specifically, the FOMC said (again, my emphasis):

“The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level. On balance, the Committee believes that the latter concern is likely to predominate for the foreseeable future. ”

The FOMC’s bottom line message: The Fed will hold the Fed fund at 1% or lower for the “foreseeable future.” While I certainly would have preferred to hear the Fed say that it was going to hold down the Fed funds rate until inflation goes up ⁵ by, say, 100 basis points, rather than for the “foreseeable future,” I was gratified that the FOMC gave zero rhetorical support to those expecting the Fed to soon begin directly manipulating the longer-term Treasury market.

The Fed will, I believe, let the yield curve “find its own market-determined level,” while indirectly influencing that level by implicitly promising (and re-iterating the promise as needed) to hold the Fed funds rate at 1% for a long, long time.

How Long Is Long?
And how long is that, wiseacres amongst you ask? Chairman Greenspan cannot be legally reappointed as a Fed governor once his one-full 14 year appointment expires on January 31, 2006. His current four-year term as Chairman ends on June 20, 2004, and President Bush has already committed to re-appointing him as chairman – how’s that for a “pre-commitment strategy!” And Mr. Greenspan has said he will accept re-appointment. In my view, and I stress that it is mine, not necessarily shared by all – or any! – of my PIMCO colleagues, I don’t think Mr. Greenspan has another tightening campaign in him.

He’s already won his four stars as the general who successfully completed the secular war against inflation, and I believe he wants – quite appropriately! – to win his fifth star as the general who pre-empted the Japanese deflationary beast ⁶ from landing on America’s shores. Monetary promiscuity in the pursuit of anti-deflation virtue is the right course, the one which Japan should have pursued, and the one which Mr. Greenspan is pursuing.

So, when it comes down to the question of how long before the Fed tightens, I believe it’s not just a matter of (1) the likely timing of visible Keynesian reflationary victory (assuming that it happens, of course!), but also (2) the timing of the end of Mr. Greenspan’s tenure. Putting those two considerations together, I think the Fed is on hold at 1% (or 25 basis lower, but not lower than that) for the Fed funds rate for at least the next two years .

And for the Treasury market, specifically the 10-year Treasury? My probability-adjusted scenarios suggest a current “fair value” range for the 10-year near where it is now – within a pitching wedge of 4%, as my colleague Mark Kiesel might say. In the context of a rock-solid Fed funds rate at 1% or less, however, I believe that Treasuries will continue to trade on the “rich side of fair,” as the risk premium for both higher inflation and tighter Fed policy will stay low until the low odds – but high consequences – of a deflationary spiral have been decisively defeated.

The Bottom Line
I believe the Treasury market is in a “rational” bubble, because the intermediate term global economic outlook is a bi-modal one, rather than a “normal” bell curve. Put more bluntly, Keynesian reflationary policies will work and inflation will go up, or they won’t work and deflation will unfold. A perpetual muddle-along scenario, the easiest one in the world to predict, is also, I think, the least likely.

As long as this is the lay of the economic land, Treasuries (swaps) are both too rich to buy and too cheap to sell. Not a pleasant place for an active portfolio manager: If it’s a bubble, playing it on the long side is a bigger fool game, but if it is not a bubble, playing it on the short side is a foolish game. The “truth” will be revealed only in the fullness of time.

Until it is, a close-to-index duration stance is the right posture for active fixed income managers, particularly after the vicious sell-off of the last several weeks. In a world of a “rational” bubble, the rational portfolio manager must worry more about being wrong than being right.

The name of the game must be to stay in the game, until time is full.

Paul A. McCulley
Managing Director
July 10, 2003
mcculley@pimco.com

1 “Paradoxically Yours,” Fed Focus, February 2002.

2 “The Morgan le Fay Plan,” Fed Focus, November 2002.

3 “Skip The Fed Fandango,” Fed Focus, December 1999.

4 “My Best Shot,” Fed Focus, June 2003.

5 http://news.ft.com/servlet/ContentServer?pagename=FT.com/StoryFTFullStory&c=StoryFT&cid=1048313970428&p=1012571727088

6 “Capitalism’s Beast of Burden,” Fed Focus, January 2001.