A Short Dialogue on the Price of the Long Treasury Bond

Alan Greenspan says:

FRB: Speech, Greenspan--Central Bank panel discussion--June 6, 2005 : 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. The yield on ten-year Treasury notes currently is at about 4 percent, 80 basis points less than its level of a year ago.... The unusual behavior of long-term rates first became apparent almost a year ago.... [W]hat are those forces? Clearly, they are not operating solely in the United States.... 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....

A second hypothesis involves the behavior of pension funds.... But world demographic trends are hardly news, and recent adjustments to funding shortfalls do not seem large enough to be more than a small part of a complete explanation.

The heavy accumulation of U.S. Treasury obligations by foreign monetary authorities is yet another hypothesis.... But, given the depth of the market for long-term Treasury instruments, the Federal Reserve Board staff estimates that the effect of foreign official purchases has been modest....

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.... The enlargement of global markets for goods, services, and finance has contributed importantly to the favorable inflation performance that we are witnessing in so many countries. That improved performance has doubtless contributed to lower inflation-related risk premiums, and the lowering of these premiums is reflected in significant declines in nominal and real long-term rates. Although this explanation contributes to an understanding of the past decade, I do not believe it explains the decline of long-term interest rates over the past year despite rising short-term rates....

[L]ow risk-free long-term rates worldwide seem to be one factor driving investors to reach for higher returns, thereby lowering the compensation for bearing credit risk.... The search for yield is particularly manifest in the massive inflows of funds to private equity firms and hedge funds. These entities have been able to raise significant resources from investors who are apparently seeking above-average risk-adjusted rates of return, which, of course, can be achieved by only a minority of investors.... I have no doubt that many of the new hedge fund entrepreneurs are embracing a strategy of pinpointing temporary market inefficiencies, the exploitation of which is expected to yield above-average rates of return. For the time being, most of the low-hanging fruit of readily available profits has already been picked.... [C]ontinuing efforts to seek above-average returns could create risks for which compensation is inadequate. Significant numbers of trading strategies are already destined to prove disappointing....

Admetos: I'm not sure I understand what Greenspan is saying. What academic model do you think he is relying on?

Thrasymakhos: You think Greenspan relies on economic models? Whoo boy, do you have a lot to learn!

Admetos: What important economic forces does he think are at work?

Thrasymakhos: You're asking me? I'm just a cardboard cut-out--a literary fiction--a stand-in for the author who says cynical things that the author does not quite say in his proper persona.

Glaukon: Greenspan mentions four factors--pessimism, demography, Asian central bank purchases, and global integration--and says that none of them account for the strange behavior of long-term interest rates.

Thrasymakhos: He does.

Glaukon: He then goes on to talk about a fifth factor--hedge funds chasing yields that "seek above-average returns... risks... trading strategies destined to prove disappointing." But he does not say that they are responsible.

Thrasymakhos: He does not.

Glaukon: But he does not say that they are not responsible either. Can we infer from his silence that he believes that they are responsible?

Thrasymakhos: He's named Alan Greenspan, not Leo Strauss.

Glaukon: Nevertheless, it is an interesting idea. How would it work out?

Khrematistikos: Let r^T be the interest rate on long-term Treasury bonds, and let r be the interest rate on short-term cash. Consider a hedge fund that believes that bond prices will not move by much in the near future--or that, if bond prices do move, its location in Manhattan and the quick fingers at the keyboards of its traders will let it be one of the first out the door. Let R be the rate of return target of the hedge fund. And let L be the leverage of the hedge fund--the amount of dollars per dollar of capital that it borrows short in order to engage in the carry trade. Am I clear?

Sokrates: Clear as daylight, Khrematistikos.

Khrematistikos: Then the relationship between these variables for this hedge fund is:

R = L(r^T - r)

Which tells us that the hedge fund's demand for long-term Treasuries (and its supply of short-term cash) is:

L = R/(r^T - r)

Is everybody with me?

Glaukon: We are, Khrematistikos.

Khrematistikos: Now what happens when the Federal Reserve raises short-term interest rates r? That narrows spreads between short- and long-term interest rates, and induces the hedge fund to increase its demand L for long-term Treasuries. That means that increases in short-term rates are associated with increased demand--higher prices--lower interest rates--on long-term bonds. In other words, hedge-fund demand for long-term Treasuries slopes the wrong way: when prices rise, demand does not fall but increases.

Admetos: And?

Thrasymakhos: And when Treasury prices start to fall, hedge-fund demand for securities will fall too. Falling prices do not reduce excess supply but produce an even bigger excess supply.

Admetos: That doesn't sound good.

Thrasymakhos: Indeed, it is not. Big air pockets. Large price declines. Financial panic.

Glaukon: Is this a scenario to worry about?

Thrasymakhos: How would I know? Do I look like New York Federal Reserve President Tim Geithner?

Comments

[Michael Carroll]

Doesn't seem like this would be a two way street.

The Hedge funds are forced to double up to keep R from going through the floor. But why couldnt they also double up if the r(T)-r spread increases too? Just like increasing the productivity of the capital, right?

Why not just chase returns over the target R if the oppurtunity is there? Why would there ever be a ceiling on the target R?

[rosswords]

Why is this so hard to understand? Too much capital chasing too few opportunities for return. There's a global capital glut. And where is a reasonable investor going to put his capital to work with confidence today? The answer is: nowhere (i.e., Treasuries). Basically, Greenspan has lost control of our money supply. Raising short-term rates is like pissing into the wind. It just blows right back in your face.

[Jason]

I am admittedly not an economist, but I believe I follow your logic above. However, doesn't your conclusion rely on the assumption that hedge funds will continue to put on the carry trade when short term rates rise? It seems to me that as r increases, (and, therefore, R declines,) traders would simply look to alternative strategies and unwind their positions.

[Movie Guy]

"And when Treasury prices start to fall, hedge-fund demand for securities will fall too. Falling prices do not reduce excess supply but produce an even bigger excess supply."

Brad, do you really believe this?

[dilbert dogbert]

Help Anne and Tante!! I need some fun comments, birds, endoftheworldasweknowitnow or what ever.

[aiontay]

Perhaps Greenspan is simply relaying messages from the Delphi oracle. Maybe that is the explanation for the current situation in Iraq. Bush asked Greenspan if he would defeat Saddam and Greenspan told him if he attacked Saddam, a great kingdom would be destroyed.

[wml]

Hypothetically, suppose the market "thought" (whatever that means) we were about (within the next ten years) to go into a massive world-wide depression, accompenied by significant deflation. What would long-run interest rates look like?

[Paul Jassup]

Could it be that age is taking its toll on Mr. Greenspan? Does he prepares his speeches or he just reads what the Fed committee hands him?

[chris]

We are too U.S.-centric with our fascination with Greenspan. If his reputation wasn't so inflated, he wouldn't have been able to do so much damage on his own or in collaboration with le Roi W. The other Brad and Dollar Crisis Duncan are already raising points on how other central banks, the A list of central banks, the ACBs, are influencing our interest rate structure.

[Aaron]

Brad,

This is an excellent explanation of 1994. Please ask Thracymakhos to get to work on 2005-6.

Thanks.

[Nate]

I immediately suspected the structure of his speech wasn't arbitrary, but very little of the popular press made the connection. Very grateful to Brad for taking the time to develop this.

"We are too U.S.-centric with our fascination with Greenspan."

This is a very good point, and I'd like to expand it from a different angle. One thing Khrematistikos' model implicitly presumes is that the only security used to generate liquidity(and carry) is U.S. Treasuries. It's certainly the safest, given that pretty much everything else runs afoul of various country or default risks.

However, that's the whole point, and a big danger: I feel Greenspan has indeed lost a lot of his control over these markets which traditionally respond to monetary handslaps *because* hedges (and hedges in investment bank clothes) have been willing to resort to alternate engines for trading.

This was not a domestic forum he spoke at. That is just as telling as the structure he used. He could easily have waited for his testimony tomorrow.

[Frank]

Awsome

[anne]

What a brilliant post. "Thrasymakhos: And when Treasury prices start to fall, hedge-fund demand for securities will fall too. Falling prices do not reduce excess supply but produce an even bigger excess supply."

There is the worry. Bold market volatility has been remarkably low since January 2000 when the bull market in long term bonds began. Can this calmness be sustained even if long term rates finally do begin to meaningfully rise? If there is as much international excess saving as Alan Greenspan appears to believe, we can anticipate continued relatively low and fairly stable long term interest rates. "If."

[anne]

Thanks, DD :)

http://www.calvorn.com/gallery/photo.php?photo=4504&exhibition=4&u=738|48|...

Male Blackburnian Warbler
New York City--Central Park, Tupelo Meadow.

[anne]

Of course, the Female Blackburnian Warbler is a lot more functional :)

[kharris]

Chasing yield (that's the way we commoners talk about what hedge funds are described here as doing, yes?) is not a straightforward action for hedge funds. In using leverage, it uses up leverage. Despite the scare stories of seemingly infinite leverage ratios among hedge funds, there are limits to their ability to borrow. They also run risk calculations on their own positions (such calculations are at the heart of the "hedge" in hedge funds). All of which is to say that there are limits to what hedge funds could be doing to make up for the flattening of the curve. Brazilian debt offers a far greater yield pick-up, without using up nearly as much leverage (Jason's point).

As to whether Greenspan's failure to dismiss hedge fund activity, in the way he dismissed the other four factors, might represent a Straussian "yes," we should also note that Fed folk are these days routinely saying that real estate speculation is a worry, but hedge funds are probably all right. That may be an attempt to address an entirely different issue than the one discussed here, but if hedge funds don't represent a risk to the financial system, then can they be holding much more long term Treasury debt on a leveraged basis than, say, LTCM did back before the splat?

Another point that somebody made recently (sorry to whoever it was), is that investors are not paying hedge funds to duplicate behavior at high initial costs that investors could undertake for themselves at low cost. In many cases, hedge funds get into long Treasury positions, but get back out when the position either pays off, or hits their stop. Carry trades are not forever. That makes the impact of hedge funds very different, other than in very special times, than that of central banks or other longer-term investors.

There is a global capital glut, but inadequate duration among high-quality instruments within that glut. Greenspan dismisses demographics as a force, but it is the intersection of demographics (gradually pushing for duration) and regulation (which risks rapidly pushing for duration) that may be at work. The US may soon require pensions to do a better job of matching the duration of assets and liabilities. The Netherlands seems on the verge of doing the same (don't dismiss the Netherlands as a factor in financial markets just because of its small geographic size). The need for duration could go up dramatically, while the duration of Treasury issuance is down. Wise managers should be scooping up long Treasuries now, before new rules go into effect.

[anne]

KHarris

Excellent :)

[bakho]

Maybe the fund managers are betting on an underlying weakness in the global economy that will prevent interest rates from rising much beyond their present levels? AG worries that moving short term interest rates up by 2% has had no effect on long term bond rates. He overlooks that 1% of that adjustment was in the liquidity trap zone (under 2%) where changes in short term rates have no effect. The 1% between 2 and 3% interest is a low traction zone.

Dropping short term rates below 2% effectively chased all investors out of short term investments. 3% is not a great inducement to switch back in to short term rates. Anyone doing so would need confidence that short term rates are going to climb substantially beyond 4%. How likely is that?

Greenspan is also committed to making short term interest rate changes only in small increments. This gives holders of long term bonds plenty of time to adjust their position if expectations for higher rates materialize. Sooner or later, the series of short term interest rate rises will stall unexpectedly and the hedge funds will be properly positioned and the managers will be handsomely rewarded.

Greenspan is getting zero help from Bush fiscal policy. Bush keeps pumping half trillion dollars worth of deficit spending every year. When fiscal and monetary policies work together, the results can be very good and the policy makers like Rubin and Greenspan look like geniuses. However, when monetary policy and fiscal policy are working at cross purposes the results are not good and Greenspan looks "over the hill". Given an administration that won't take any blame for its own mistakes, all the blame for the current state of the economy gets dumped on Greenspan.

This is a point where fiscal policy could soak up some of the speculative capital and apply it to debt reduction at little cost to the economy. I am not holding my breath. With negative fiscal policy help from Bush, Greenspan has reason to worry.

[Spencer]

Over the last 50 years the single best indicator of the yield curve has been the unemployment rate less the inflation rate. Interestingly, the rule that we get a negatively sloped yield curve when the inflation rate is higher then the unemployment rate almost has a perfect record.

But this rule for the yield curve has worked almost perfectly the past year and says there is nothing at all unusual about the behavior of the yield curve.

It has done exactly what it has always done historically.

[Jennifer]

Spencer, the inflation rate is not higher than the unemployment rate. Please explain your relation of unemployment, inflation and yield curve slope a bit more fully.

[Ken Houghton]

Jennifer - We don't have a negatively-shaped yield curve. Think of Spencer's first two sentences as separate paragraphs.

Round figures (as in, I haven't looked up last week's UR or the most recent inflation indicator) 5.2-2.4 = 2.8, which is fairly close to the 2.94% yield of the current 3-month bill.

Which leaves the question of: if Funds are at 3.0%, and projected to go up, why is anyone buying the SHORT end of the curve? I can accept wml's reasoning as a valid reason to buy 10-year Notes at these levels (though it requires only a small portion of the market to be using that reasoning, or the Fed to be Dead Wrong about tightening), by why would anyone be buying the short end.

In short, all else being as it is, why do we NOT currently have an inverted yield curve?

[Nate]

Bakho,

"Greenspan is also committed to making short term interest rate changes only in small increments. This gives holders of long term bonds plenty of time to adjust their position if expectations for higher rates materialize."

That's a great consideration. Does it also implicitly mean that all these efforts to increase central bank transparence, including use of the term "measured," were all actually ironically damaging to stability because they reduced interest rate uncertainty?

kharris,

"... we should also note that Fed folk are these days routinely saying that real estate speculation is a worry, but hedge funds are probably all right."

This is true as far as it goes, but I think that may be a mischaracterization of their concerns. Greenspan et al. clearly believe hedge funds are very good for market efficiency despite the fear they've traditionally invoked in a lot of people. Even in this speech, he's careful to defend hedges and derivatives:

"I trust such an episode would not induce us to lose sight of the very important contributions hedge funds and new financial products have made to financial stability by increasing market liquidity and spreading financial risk, and thereby enhancing economic flexibility and resilience."

Belief in the hedge fund as a beneficial player in the market doesn't imply support of an arbitrary set of strategies or yieldlust by any player. With hedge funds, this could lead to poor returns and a devastating exodus from the sector. The trouble here isn't hedge funds; it's the investors in hedge funds and their expectations leading these funds to increasingly nutty strategies. Greenspan has spoken earlier on the same concept:

http://www.federalreserve.gov/boarddocs/speeches/2005/20050505/default.htm

and others indirectly,

http://www.federalreserve.gov/boarddocs/speeches/2004/200402252/default.htm

"We are also seeing some investors attempt to increase nominal yields by investing in lower-rated bonds. But the skills that this association's members practice, remind us that the goal should be appropriate "risk management," that is, given an organization's risk appetite, the attractiveness of higher yields must always be balanced against the increased level of risk in the transaction. And in times of turns in business and interest rate cycles, estimating these tradeoffs can be more difficult."

And there's a large amount of babble from the '98-'99 period.

As an aside, I feel pretty bad for Greenspan. Some congressman just asked him a question about the falling rates on "federal reserve bonds." If these are the ones that sit on the finance committee...

[Ken Houghton]

Near the end of the speech, Greenspan says: "Consequently, after its recent very rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy. But =so long as banks and other lenders to these ventures are managing their credit risks effectively=, this necessary adjustment should not pose a threat to financial stability."

The OCC et al. basically declared that banks are not managing their credit risks effectively on something as simple as Home Equity lending. ("The agencies have found that, in many cases, institutions’ credit risk
management practices for home equity lending have not kept pace with the product’s rapid growth and easing of underwriting standards." -- CREDIT RISK MANAGEMENT GUIDANCE FOR HOME EQUITY LENDING)

Since the Board of Governors of the Federal Reserve System are the second signatories on that release, we should be able to presume that Mr. Greenspan knows of the findings. Realistically, then, Mr. Greenspan knows that his caveat, while true, does not likely reflect current market practice. (It should be intuitive that managing the credit risk of a HELOC is a lot easier than managing the credit risk of a hedge fund.)

Is anyone else therefore not comforted by Mr. G's remark?

[Jennifer]

Thank you, Ken Houghton. Then we are thinking in similar terms. I have an idea that I am playing with:

Corporate savings here and in Europe are near record levels, and there must be enormous amounts of savings by international energy producers. Where is Norway's oil revenue going? Saudi Arabia's? There is simply not much investment of oil revenue that I can find. I suspect lots of corporate money is going to buy Treasury debt. I never use a money market, but rather buy Vanguard bond funds with any money I wish to keep liquid. I adjust durations, but I never leave the bond market.

[kharris]

Nate,

I'm not sure what I said to get you thinking I meant the Fed supports "an arbitrary set of strategies or yieldlust by any player." My notion, again, is that --

1) The Fed may be addressing some other issue than the one we are addressing here when it discusses risks to financial markets from hedge fund activity, but --

2) If the Fed's apparent low level of concern over the risk represented by hedge funds is predicated on hedge funds current holdings and strategies, then the Fed must assess that hedge funds are not an overwhelming force in the Treasury market. If the latter case holds, then Greenspan's assertion that hedge fund activity doesn't account for low long end rates is not a big fat fib (Straussian).

Greenspan has been challenged during his JEC testimony today to explain the low level of long rates, and he settled on a single cause. Since low long rates are a world phenomenon, we need not look within the US for an explanation. Widespread improvements in education and diffusion of technology outside the US is what Greenspan settles on.

[Silent E]

Long term rates are falling, even as short term rates rise?

Perhaps a flattening (and potentially inverting) yield curve means just what it always means: recession is coming.

* Labor markets are weak in the US because the Administration prefers to help capital at the expense of labor.
* Broad consumer demand is weak and will stay weak for the near term because of weak employment in the "Neiman-Marcus economy".
* There is a housing bubble. No one except the Realtors deny it now...
* There is a dollar bubble. America's trade deficit growth is too large to be sustainable - even with Asian Central Bank suport - and pressure for China to re-value is growing.
* European growth is slowing again, and the EU Constitution mess is unsettling.
* Japanese banking, finance, and fiscal policy is still a mess. Better than 1990, but please - it's been 15 years already!
* There are serious long term crises in public pensions in Japan and Europe, private pensions in the US, and in healthcare everywhere.

As Greenspan says, "This is certainly a credible notion. But periodic signs of buoyancy in some areas of the global economy have not arrested the fall in rates."

Well, of course not: the periodic signs of buoyancy have given no suggestion that the serious structural imbalances in the global economy are being fixed.

[anne]

Putting together all of Alan Greenspan's suppositions, there is a considerable amount of international dollar accumulation and saving relative to investment opportunities. A reasonable portion of this saving has to be coming to the American bond market, whether to buy Treasury or mortgage or corporate debt. The proportion of saving in several Asian countries is astonishing. We are capturing international saving, much to the surprise of many analysts.

[Nate]

kharris,

This sort of comment is what I was referring to:

"If the Fed's apparent low level of concern over the risk represented by hedge funds is predicated on hedge funds current holdings and strategies..."

I disagree. I don't think that there's a low level of concern about these trades being performed. There's a low level of concern about hedge funds as an entity, because they're beneficial on net, but the "predicated on hedge funds current holdings and strategies" doesn't necessarily follow:

"To meet this demand, hedge fund managers are devising increasingly more complex trading strategies to exploit perceived arbitrage opportunities, which are judged--in many cases erroneously--to offer excess rates of return.... Significant numbers of trading strategies are already destined to prove disappointing, a point that recent data on the distribution of hedge fund returns seem to be confirming.... But so long as banks and other lenders to these ventures are managing their credit risks effectively, this necessary adjustment should not pose a threat to financial stability."

Sure doesn't sound like a ringing endorsement of these trades.

I missed that point by Greenspan, I'm afraid. I did hear him mention globalization as a reason for the expanding current account surpluses and deficits around the world. I'll be eager to hear it recapped later, and thanks for letting us know about it.

However, his prepared remarks don't suggest the same point of view, and it's unlike Greenspan to get caged in Q&A and forced to respond contrary to his prepared remarks:

"The unusual behavior of long-term interest rates first became apparent almost a year ago. In May and June of last year, market participants were behaving as expected. With a firming of monetary policy by the Federal Reserve widely expected, they built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with a rising federal funds rate. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In March of this year, market participants once again bid up long-term rates, but as occurred last year, forces came into play to make those increases short lived. There remains considerable conjecture among analysts as to the nature of those market forces."

There aren't many "market participants" that build large short positions. I view this in support of the hedge fund hypothesis.

[Dave]

Maybe instead of ranting only about being ruled by republican idiots, you could offer to teach some basic economics to the entire congress. Watching this Greenspan testimony I am appalled at the level of knoweledge and Facts.

Ha, I just heard that the tax cuts are going to buy Islands and factories in China... I thought it was the Chinese trade surplus that was leading to China buying too much of our assets. Very confused...

[Nate]

Yeah, Dave, that was Representative Maurice Hinchey (D - NY), the same one who asked about Federal Reserve bonds. His concern there was apparently that when the wealthy go to invest, they do so by buying pacific islands and Chinese factories. Whewf.

[anne]

A year ago during the spring, oil was priced about 35 dollars a barrel. This spring oil has been 50 to 55 dollars a barrel. Hundreds of billions of dollars in oil additional revenue has accumulated. Other than in Venezuela, there is fairly little investment of the funds. Exxon Mobil has not significantly increased investment relative to earnings. Again, I imagine these funds are finding a way to American debt markets. Remember, the dollar has stabilized and climbed against other major currencies since December. Why not hold Treasury debt?

[anne]

KHarris

"There is a global capital glut, but inadequate duration among high-quality instruments within that glut. Greenspan dismisses demographics as a force, but it is the intersection of demographics (gradually pushing for duration) and regulation (which risks rapidly pushing for duration) that may be at work."

The Treasury has issued fairly little long term debt, corporations have generally fine earnings and less need for long term debt than in the past. There is demand for long term debt simply because of increased pension liabilities. This is only a partial answer to the low long term rates we are seeing, but put all the pieces of the puzzle together and remember there is an international market for American debt and we have some sense.

[anne]

Alan Greenspan has often repeated how impressed he is by the increased flexibility of market here and abroad. We have an international capital market, and despite complaints about bubbles and bubbles private and public investors are comfortable holding dollar assets. Again, remember, we have a large trade deficit and international central banks are accumulating dollar assets.

[kharris]

Nate,

The miscommunication seems between us seems not to be over substance, but the use of English. When I stick "if" to the front of a sentence, I intend it to mean something. You seem to miss that subtlety. You go on to say you disagree, but there is nothing in what you quote with which to disagree. You offer the "if" part of an "if/then", but not the then. I didn't offer the premise as a fact (that "if" business again), but as a premise. Logically, you'd want to disagree with the conclusion, which you excluded.

But it gets better.

"I missed that point by Greenspan, I'm afraid. I did hear him mention globalization as a reason for the expanding current account surpluses and deficits around the world. I'll be eager to hear it recapped later, and thanks for letting us know about it.

However, his prepared remarks don't suggest the same point of view, and it's unlike Greenspan to get caged in Q&A and forced to respond contrary to his prepared remarks"

Not my fault if you missed it. It's in there.

I have to say, though, I am impressed with your vast knowledge of Greenspan's thinking. "...his prepared remarks don't suggest the same point of view, and it's unlike Greenspan to get caged in Q&A and forced to respond contrary to his prepared remarks" In other words, he couldn't have said what I said he said, cause you didn't catch it. Very nice.

So by all means go through the transcripts. But first, go away.

[anne]

KHarris

"Widespread improvements in education and diffusion of technology outside the US is what Greenspan settles on."

The implication is American or European economic and market adjustment flexibility has become quite general internationally. I would have argued Japan is an exception, but Japan has actually adjusted to domestic shocks in international dealings. Rober Rubin suggested this, but I did not understand till recently.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=4626&u=185|8|...

Great Blue Heron
New York City--Central Park, The Loch.

[piotr]

Khremastikos makes some apparent sense, but not real sense; I will make a counter-reasoning
in points.

1. Why would a hedge fund have a target for profit? It makes no sense, because a larger ta
rget would be more profitable. It implies that it would not be rational to limit your strat
egy by a target on profits, instead, there have to be other limits that determine the parame
ters of the investment.

2. The critical limitation here is the willingness of third parties to provide financing.
As the leverage increases, that willingness eventually decreases. The willingness can imply
the available interest rate, or even the loan availability, once the interest rate is higher than that of the long bonds, they are as bad as infinite.

3. Point 2. shows that a critical calculation is performed by the lenders to the hedge fund
s rather than by the hedge funds themselves. If you lend 1 dollar short term, and the colla
teral is 1 dollar worth of bond, then if the bond declines by 1c in price the borrower can default and you loose your 1c. OTOH, if the collateral is 1.1 dollar worth of bond, that unpleasant eventuality occurs when the bond declines 11c.

4. How the calculation of the lender changes after a change of the price of bonds? The lender does not give a damn how large the long interest rate is, but what is the risk of the pr
ices declining more than the cash portion of the hedge fund portfolio. So the limiting fact
or is the projection of the future prices of bonds, or more precisely, the estimated probability distributions of various projections.

I conclude that the only explanation of the increase demand is that the lenders concluded that the prices of long bonds will be at least stable in the next 3-6 months.

[Nate]

Please try to keep things civil rather than telling people to go away from a public forum. I excerpted your later comment for succinctness. Sorry. Rather than argue about semantics, we'll use this one instead:

kharris: "That may be an attempt to address an entirely different issue than the one discussed here, but if hedge funds don't represent a risk to the financial system, then can they be holding much more long term Treasury debt on a leveraged basis than, say, LTCM did back before the splat?"

Nate: "I disagree. I don't think that there's a low level of concern about these trades being performed. There's a low level of concern about hedge funds as an entity, because they're beneficial on net..."

To reiterate, hedge funds themselves are not a risk. These trades and the expectation of high returns amongst investors in them are. I then used several quotes from Greenspan to back up my opinion, and demonstrate they could indeed be major players.

Again, there's nothing in his *prepared* remarks. To the contrary, he again states:

"There remains considerable conjecture among analysts as to the nature of those market forces."

http://www.federalreserve.gov/boarddocs/testimony/2005/200506092/default.htm

You in fact suggest he contradicts his Monday night speech:

kharris: "Greenspan has been challenged during his JEC testimony today to explain the low level of long rates, and he settled on a single cause. Since low long rates are a world phenomenon, we need not look within the US for an explanation. Widespread improvements in education and diffusion of technology outside the US is what Greenspan settles on."

Greenspan: "... 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. The enlargement of global markets for goods, services, and finance has contributed importantly to the favorable inflation performance that we are witnessing in so many countries. Although this explanation contributes to an understanding of the past decade, I do not believe it explains the decline of long-term interest rates over the past year despite rising short-term rates."

That's why I'd like to read it in transcript.

[Nate]

To avoid another quabble, forgive me, I'll change "contradicts" to "is seemingly at odds with, given one facet of the nature of widespread improvements in education and technology diffusion is generally larger markets with cheaper production of goods and services."

[Silent E]

anne:

"There is demand for long term debt simply because of increased pension liabilities. This is only a partial answer to the low long term rates we are seeing, but put all the pieces of the puzzle together and remember there is an international market for American debt and we have some sense."

And thus the global housing bubble makes perfect sense as lenders have found a rapidly growing group of long-term borrowers with a seemingly-insatiable appetite for additional capital.

[anne]

Silent E

"And thus the global housing bubble makes perfect sense as lenders have found a rapidly growing group of long-term borrowers with a seemingly-insatiable appetite for additional capital."

Nice point, and I am thinking of the rest of your argument.

[David A. Spitzley]

PIOTR

"1. Why would a hedge fund have a target for profit? It makes no sense, because a larger target would be more profitable. It implies that it would not be rational to limit your strategy by a target on profits, instead, there have to be other limits that determine the parameters of the investment."

I may be overreaching here, as I've yet to start my dissertation work, and finance isn't my area of expertise (to the extent I can claim one), but my response to this question was that the target profit level (actually, it was defined in the dialogue as the target rate of return) would have been selected based on some sort of risk-preference behavior on the part of the firm managers, e.g.

U = f(R,x(R))

where x(R) is some estimate of the risk of loss associated with pursuing rate of return R. Overall the idea of that the firm would select a desired value for R seems pretty reasonable to me.

[anne]

KHarris

Points out to us the increasing need for pension funds to extend duration to cover what are hundreds of billions of dollars of uncovered liabilities. This will provide an important source of demand for Treasuries for quite some while. Well done.

[anne]

KHarris

"The US may soon require pensions to do a better job of matching the duration of assets and liabilities. The Netherlands seems on the verge of doing the same (don't dismiss the Netherlands as a factor in financial markets just because of its small geographic size). The need for duration could go up dramatically, while the duration of Treasury issuance is down. Wise managers should be scooping up long Treasuries now, before new rules go into effect."

[anne]

The short-fall in corporate pension assets was 354 billion dollars at the end of 2004, according to Pension Benefit Guaranty Corporation.

[anne]

Spencer

Reminds us that the yield curve is near a normal slope now, where a yield ago it was as steep as had been recorded since 1954. The only comparably steep slope to the yield curve was recorded in 1989. There was ample reason for borrowing short and lending long a years ago, and shrewd bond investors understood. Nice.

[anne]

The period from January 2000 till now stands as the most remarkable bond period in 50 years. The Vanguard Long Term Investment-Grade Bond Fund has averaged more than 11% a year, while the S&P has lost about 2% a year.

[anne]

Thanks Brad and all :)

This post and comments are simply excellent and set into proper context many ideas about the bond market.

[piotr]

DAVID,

this is very much the same thing: Khrem (I will use a nickname) reasons as if we could just use two equation: one for the profit and two interest rates, one equating profit rates to a constant.

However, if the risk is a limiting quantity, than you can increase the leverage only if it does not increase the risk. If the limitation on risk originates internally in the hedge fund or externally in the lending institutions, the result is the same.

To keep the (perceived) risk constant, you can increase the leverage only if you are more optimistic about the future.

Thus purchases of hedge fund do not represent demand originating in financial alchemy, but in the belief that the future demand will be robust.

At least in the stock market, rising prices may have the effect of convincing market that they will increase even more. For example, it is not outlandish to conclude that the Chinese government is trapped into protecting their currency against appreciation.

My theory is that the leaders of China will get out of the trap and temporarily collapse their own economy in a way that will combine that with some acute conflict with USA and associated nationalistic fervor. That will allow them to stick to power for a couple more years, and then the economy will return to normal and the dynasty will regain the Mandate of Heavens. But it is a risky solution so it will be delayed as much as possible.

[Jack]

Piotr,
the hedge fund managers have to tell their investors what they are going to do. They will want to say that they have low correlation to markets and are targetting a certain level of return. If they are aiming to deliver on this proposition and stay in business and their strategy involves that kind of trade, then they will feel pressure in the direction described by Brad.
Of course this might not be optimal behaviour but they have promises to keep and they might not be looking at the maths in quite the stark way that Brad does. Very likely this will be creeping up on them slowly and be presented as terms on particular and not quite comparable deals. Not only that their remuneration structure may not kick in fully unless revenues exceed a fixed minimum. In fact this point might be the strongest I have to make. Many hedge funds are one trick ponies and have 2%/20% fee structure. Whenthe strategy runs out of steam they will be under all kinds of pressure.

As a second point, many of the LTCM trades, in particular the on the run/off the run trade would have had much smaller yield curve posiitons than simple carry trades.

[chris]

kharris:

"In using leverage, it uses up leverage. Despite the scare stories of seemingly infinite leverage ratios among hedge funds, there are limits to their ability to borrow." Still scared, sorry. Supposedly some number of investors in these things are borrowing their investment, so there is another layer of leverage at the foundation level. You're quite informative, your comment on how we all have to edit our thinking as we progress on the other post reminds me to keep thinking, stay aware.

bakho, my deere, you almost had me empathizing with Greenspan. It almost sounds like he'll be working as a Walmart Greeter.

[glenn]

What about mean-reversion? For much of its history (up until early-mid 2oth century) the long bond averaged 4% or so.

I'd also point out that Greenspan - a man who loves the limelight - will do nothing to hurt his legacy. I think he'll do nothing to risk an inverted yield curve before he leaves. He'll let the next guy (or gal) deal with all-hell-breaking-loose-ities.

I think when it comes to hedge funds, there are waaaay too many people being given waaaay too much money. There are only so many talented people in the market, and I think it's clear, that the vast majority of hedge funds (if not funds) now are managed by average joes (and janes) who are attracted by the payouts. All they need is return, and all they want is yield. Take a look at CDOs and CMOs....some traches, the riskiest tranches, are decent yielders. With, say only 100% leverage (not even the LTCM 30x-ish leverage) a manager of, say, a lousy $200 million, will become a multi-millionaire several times over. Sure, it'll be 2 or 3 years before it blows up (and it will), but all the need is ONE year of absolute positive returns, not relative to any benchmark.

This isn't all hedge funds, or even a majority. But there are alot of jokers doing these trades, and it'll likely end badly, but only after they've scoffed off to the beach.

[anne]

When a portion of the market becomes in effect the market, that portion can only expect market returns over time. But, hedge fund costs are quite high so the average hedge fund will return significantly less than the market and this is what we are indeed seeing.

[anne]

http://www.nytimes.com/2004/12/09/business/09scene.html?ex=1119411711&ei=1&en=50f61ab685e29952

Hedge Funds Better at Managing Data Than Managing Money
By ALAN B. KRUEGER

HEDGE funds have grown at supersonic speed. In 1990, about $50 billion was invested in hedge funds; today, the amount is estimated at $1 trillion.

Does superior performance explain the rapid growth? No, says Burton G. Malkiel, a professor of economics at Princeton University, and Atanu Saha, a managing principal at the Analysis Group, a consulting firm. The researchers recently completed a study that challenges the often-made claim that hedge funds, in general, produce lofty returns.

Hedge funds are a diverse set of investment funds that typically cater to wealthy clients and institutions. The funds pursue various strategies, like holding both long and short positions, and often employ substantial leverage. Their fees are usually much higher than those charged by mutual funds or other financial assets.

Data on the performance of hedge funds comes from indexes like the CSFB/Tremont Index or the Van Hedge Fund Index. Those indexes are generated by companies that advise investors and operate funds.

"Hedge funds in aggregate," Van Hedge Fund Advisors boasts on its Web site, "in most multiyear periods, have provided both superior returns and lower statistical risk than the S.& P. 500 or mutual funds."

The catch, according to Professor Malkiel, is that the information on performance is voluntarily provided to the organizations who track the funds. Because a good record helps attract investors, funds have a tendency to start reporting results only after they have achieved some success. Funds that are losers right out of the gate may never be represented in the database.

Furthermore, when funds start reporting, they have the option of "backfilling" their data, or providing information on returns for previous months. If a fund was successful in preceding months, it has an incentive to backfill its data to increase its attractiveness to investors.

This process creates a "backfill bias," because better results are overrepresented in the database. It is as if the Boston Red Sox waited until 2004 to report their World Series success, while the Yankees started in 1923; both franchises would look like smashing successes....

[glenn]

Not to mention "Survivorship Bias."

I think alot money has gone to hedge funds, at least initially, because their returns, as a group are fairly uncorrelated with the equity market. It's just another (and expensive) form of diversification.

But what we're seeing in the market - low volatility, low absolute returns, and low interest rates - is at least to some degree, and perhaps largely, due to the mass of money that has moved into these divergent strategies. If, at the extreme, half are long and half are short, volatility will grind lower and lower.

That, in and of itself, is not a bad thing. Being able to short and profit when assets decline in value drives inefficiencies out of the market, however, it's the leverage, it's the fee structure, and it's the relative inexperience that will cause problems.

Seriously, who wants to give 2% management fee and 20% of the upside? I guess alot of people. It's one thing if they hold their value, or rise, when the markets collapse (2000, 2001, 2002), but in these years, when the markets go up single digits?

But why don't they instead just buy some Berkshire Hathaway?

[chris]

too bad we couldn't take a vote between global money glut and globalization. I'd vote for money glut

the other malarky about India, China and education sounds like his cheering for productivity. In the past one wall mart greeter could greet 30 shoppers an hour, but now he can greet 32. the UA flight attendent formerly had to hand out peanuts and hear lame jokes about same, now no peanuts so no jokes, what are the hedonic aspects of that? how do you account for wonders like that?

Greenspan, what does he know? This is the guy who noted the financial analysts predictions for business growth in Jan. 2000 and in Feb. 2004 lauded the possible savings in ARMs. Listen to Greenspan, head in the opposite direction, coming soon. Honey is to Mr. Magoo as Greenspan is to the W adminsitration.

[bakho]

Alert;

Stafford Loan, is set to rise to 5.30 percent from 3.37 percent on July 1. Lock in your rate today.

http://www.boston.com/news/education/higher/articles/2005/06/09/rate_to_rocket_on_popular_school_loans/

[Ari]

Chris

Alan Greenspan has been adept at reading the economy since coming to the Fed. Simply mocking Greenspan will teach us nothing, and as Brad has written many times monetary policy has been excellent under Greenspan. By paying close attention to Greenspan I have learned a great deal. I have criticisms with Greenspan's fiscal ideas but little else, and Greenspan does not make fiscal policy.

[chris]

Ari:

thanks. You are right about the smartie pants comments. You are more aware of the implications of what he has been trying to do over these last 18 years than I am. I am of the opinion that he coulda, shoulda raised margin requirements or raised the s-t rate earlier in the late nineties to try to tamp back speculation. His own definition of inflation was a material change of attitudes which occured in the late 90s but he didn't act on it.

Following up with the non-reaction to the internet bubble, I think he cut too fast and deep in the early 2000s which now leads us to a new bubble which might have more serious implications for more Americans when it pops.

I can only read a diverse group of writers and make a decision. I'm running on the level of belief while you can analyse and conclude. I think his reputation is high amongst liberal economists sometimes reaching the personality cult of CEO stars. I think that inflated status is dangerous. We have 300 mil people here; someone else could have filled the post for a term.

[David Foster]

Interesting analysis...but it seems to imply that hedge fund target rate of return is fixed, whereas the amount of leverage it employs is variable. Why wouldn't it always use whatever leverage ratio it thinks it can get away with, and thereby achieve higher returns when spreads are higher?

And how narrow do the spreads need to be before the carry trade stops working at all?