Beware the Bond Pundits!
Beware the bond pundits. They seem to have an agenda. It does not include profits for the average investor.
I am trying hard not to go into rant mode. Mrs. OldProf sternly instructed that I could not say "ignorant, clueless bozos." In this redacted version you get a milder story. Many widely-esteemed bond market pundits have a viewpoint that we regard as misguided, and costly to equity investors. Here is why.
Japanese investors — government and individuals — are major holders of US debt. The tragedy of the earthquake and tsunami will require cash for rebuilding. Some observers are highlighting this consideration and the implications for US debt. The conclusion of much of the punditry is that this will cause a collapse of the US bond market, followed by a collapse of equity markets.
The erroneous analysis of the bond market is the most blatant example of a major problem for investors. Even if you are intelligent, attentive, and focused, you will be led astray by what you see online.
Some issues require actual skill to analyze, and the Japan situation is a good example. Let us take a closer look.
The Typical Argument
Most of the talking heads on TV and the big-time blog writers cite the possible selling of US treasuries by the Japanese government and citizens as a major threat. I do not want to pick on any specific source — there are so many candidates. The general argument is that the Japanese will be selling, China is no longer buying, and — Woe is me! — what will happen next? Since no one will be left to buy, the US bond market will collapse and equities will follow.
The general appeal of this argument comes from the "everyman" approach favored by most economic bloggers. This approach depends upon oversimplifying economics, transactions, and relationships.
Here are some simple facts:
- The leading economic bloggers are not economists. Seeking Alpha (a great source where I am happy to contribute) ranks the top 20 in the economics category by popularity. Only two of these authors have genuine economic credentials (I am not including myself).
- A typical pop economics article tells readers what they already "know." It does not educate nor inform. It treats economics as something everyone already knows from practical experience in reading the news or doing the family budget. There is nothing that needs to be learned. This serves to reinforce existing misinformation.
- The pop economists treat every economic relationship as a bargain between two unitary actors. "Japan is selling. Who will buy?"
- Most of the real economists do not write on the topics of greatest importance to investors.
This is a sad situation. I wish that universities would reward economists who ventured into the field of finance and investments, helping to highlight truth seeking. The upcoming Kauffman Foundation conference for economic bloggers may provide a forum for this topic.
How does this apply to Japan and the current bond market?
The right way to analyze this problem would be to analyze the market microstructure to get a handle on demand. Supply is probably easier, since the normal trading is known and so are the Treasury auctions. The main point is that a serious analyst would use microeconomic principles to derive a demand curve. If the Japanese demand is reduced, that would shift the entire curve. Demand and supply curves would intersect at a somewhat different point, suggesting a different clearing price for US Treasuries. To do this properly requires some data and assumptions about the underlying demand and supply curves.
The analysis would include the following facts (some from a 2008 Fed paper on market microstructure):
- Overall federal debt is about $14 trillion. The Japanese government holds about $700 billion and might need to liquidate about $100 billion or so. This would not occur all at once.
- Daily trading volume was over $500 billion in 2007 and this did not include futures trading.
- The Fed QE II program was for $600 billion over eight months. The pundits are still arguing about whether this buying reduced interest rates. Those who want to claim it was ineffective point out that rates moved higher. Many of these same people now say that the Japanese selling will cause a market meltdown.
A Simple Rule for Reading Economic Articles
Does the author understand that economics involves a distribution of demand and supply? That prices are determined at the margin? That small changes in price may imply great changes in quantity (or vice versa)?
To illustrate with the current example, the Japanese government, should it choose to sell bonds, cannot be treated like the owner of a piece of real estate — all or nothing at a single price. The Japanese government (or citizens) will be willing to sell more bonds at a higher price, and might not sell any at a low price (choosing to raise funds in another way). The decision is a distribution, not a single, all-in transaction. It certainly does not happen at one point in time.
If you are reading an economic pundit who does not understand marginal pricing, just turn the page.
The market for US debt is deep and liquid. Small price changes draw many more bids from those using yield-based asset allocation models, a large part of the market.
I can't believe that so many clueless bozos mistaken analysts are so eagerly embraced by the media and readers. I guess nothing beats a good story.
Here is a little mind game that you might enjoy. As you watch the NCAA basketball tournament, switch to an NBA game. Ask yourself if you could tell the difference between college and pros without announcers or uniforms. If you are a real fan, you would find it easy. Similarly, you could tell the difference between pro and college football by the plays and the speed of the players.
Now try it on economics articles or TV appearances. See if you can spot the real economists. If you cannot, you are probably making many poor inferences about economics.