Monday, August 23, 2010

A Bond Bubble?

Prof Paul Krugman does not think so. Using a simplified Taylor Rule and projections for employment and inflation from the CBO he derives a predicted fed fund rate which looks like this:

Low rates for years to come!!!
He adds: "That’s right: four years of near-zero short-term interest rates. Does a 10-year rate of 2.6 percent still sound so unreasonable? And bear in mind that I’m not using some doomsayer’s forecast; I’m using the staid folks at the CBO.

And just for the heck of it, I asked what interest rate on a 10-year security would yield the same present value as investing in short-term debt at the predicted rates, and rolling it over each year. (Actually, I cheated slightly, because I was getting tired; I considered a bond in which there are no payments along the way, just repayment of accumulated interest and principal in year 10; but I’m pretty sure it doesn’t make much difference).

And the implied interest rate was … 2.6 percent.

Here’s what I think is going on: aside from the obviously intense desire of some of the bond bubble folks to see a fiscal crisis — they’ve been planning for it, and they’re not going to take no for an answer — my sense is that a lot of people just can’t bring themselves to face the reality that we’re likely to be in a zero-interest world for a long time. They just keep assuming that the Fed is going to raise rates soon, even though there is absolutely nothing about the macro situation that would justify such a rate increase."

If no bubble and the bond market is right expect some dismal economic prospects for much longer. Bu hao!

No comments: