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For simplicity, let’s assume that the Fed’s policy instrument (now that the federal funds rate is stuck near zero) is the 10-year Treasury note. As an example, suppose the yield is 4%. In that case, it’s all but certain that the Fed, if it chooses, can do something to stimulate the economy and raise the inflation rate.

For example, suppose the Fed were to bid the 10-year note yield down from 4% to 1%. It would take out a whole slew of marginal noteholders in the process. Banks that had been satisfied with a 4% return would be unsatisfied with a 1% return and would lend more aggressively. Domestic investors that had been satisfied with a 4% return would be unsatisfied with 1% and would bite the bullet and buy stocks. International investors would be unsatisfied and would shift their investments into foreign assets, thus weakening the dollar and making US products more competitive. Households would refinance their mortgages and spend some portion of the increased cash flow. Others who previously couldn’t afford houses could now afford them, so demand for houses and home furnishings would go up. And so on. With such a huge policy action, it’s virtually certain that business activity would accelerate enough to reverse any deflationary pressure.

One way to think about that example is in terms of the natural rate of interest, the rate at which the prospective scenario theoretically crosses the line between disinflation and inflation. Suppose the expected inflation rate is 1.5% and the natural real interest rate on the 10-year note is 1%. Then, with a 4% yield, there is a disinflationary gap of 1.5% (that is, 4% nominal yield, minus 1.5% expected inflation, minus 1% natural real interest rate). If expectations remained constant, the hypothetical policy action – reducing the nominal yield to 1% – would reverse the 1.5% disinflationary gap into a 1.5% inflationary gap, thus switching the prospective scenario from one of disinflation to one of inflation.

However, expectations would not remain constant. Naturally, if the prospective scenario switched from disinflation to inflation, the expected inflation rate would rise. Moreover, since the inflationary scenario involves an economic recovery, the natural real interest rate would rise too. When disinflationary stagnation was expected, there wasn’t much reason to borrow money, or to invest the money one already had in any productive project, so it would require a very low interest rate to get an inflationary scenario going. When inflationary recovery is expected, there are much better investment opportunities, so even a relatively high interest rate could justify the kind of demand that would lead to recovery and inflation. Perhaps the natural real interest rate would rise to 2% and the expected inflation rate would rise to 2.5%, leaving a very large (3.5%) inflationary gap at a 1% nominal yield.

Indeed, these expectations would even create an inflationary gap (of 0.5%) if the yield were still at 4%. Thus the Fed could let the yield go back up to 4% and still produce the desired effect of stimulating recovery and raising the inflation rate. In fact, the Fed wouldn’t even need to bid down the yield in the first place. If the Fed had enough credibility, all it would have to do is threaten to bid down the yield. It’s even possible to come up with a plausible example where the Fed’s threat to bid down the yield causes the yield to go up. That’s the magic of expectations. And that’s why, when the yield begins at 4%, it won’t be very sensitive to disinflationary shocks. A disinflationary shock will push down the yield a little bit, but the Fed can make a credible threat to push it down further, and, paradoxically, the result will be that it won’t have to go down further. Consequently, a yield of 4% is fairly stable.

But now let’s take another example. Suppose the yield starts out at 1%. The economy is expected to be weak, so the natural real interest rate (for the 10-year note) is 0%. Say the expected inflation rate is 0.5%, leaving a disinflationary gap of 0.5% even at the 1% nominal yield. What can the Fed do?

Theoretically, given the parameters that I’ve imagined, the Fed can still shift the scenario from disinflation/stagnation to inflation/recovery by bidding the yield down to zero. That would leave an inflationary gap of 0.5%. But in reality, we never know exactly what the natural real interest rate is. If the yield were 1% and the economy still appeared to be stagnating, bond market participants would rightly question the Fed’s ability to revive the economy. A drop in the yield from 1% to 0% might do the trick, or it might not. Given this lack of confidence in the Fed’s ability to revive the economy, the threat to do so (by hypothetically bidding down the yield) would no longer be credible. The only way the Fed could potentially revive the economy would be by actually bidding down the yield.

And what if the Fed chose not to do so? Since I’ve assumed a disinflationary gap, the inflation rate would, in the absence of policy action, tend to decline. To the extent that this decline were unanticipated, yields would then tend to fall. Thus, no matter what the Fed does or doesn’t do, the fact that the yield is low (and thus the Fed lacks a credible threat to revive the economy) creates a reason why the yield should go even lower.

Of course, in equilibrium, this decline should have been anticipated and should already have happened. But suppose there is a disinflationary shock. It has the direct effect of lowering the yield because it is disinflationary in its own right. But then it has the indirect effect of reducing the Fed’s ability to make a credible threat to revive the economy. This indirect effect causes the yield to decline more than it otherwise would. Thus, the lower bond yields go, the more unstable they become in response to shocks.

[Note that the process also works in reverse. If bond yields are low, and we are in a disinflationary environment, but we get an inflationary shock, not only does it raise the yield by increasing inflation directly, it also increases the Fed’s ability to stimulate the economy, thus adding an additional inflationary component and raising the yield still further. Conversely, when bond yields are high, there is little question of the Fed’s ability to stimulate the economy, so an inflationary shock does not alter that perceived ability, and it has only its direct effect on the yield.]

So what does all this mean? Well, for one thing, it suggests that, with bond yields having fallen significantly over the past few months, the Fed ought to get off its ass and start making credible threats to revive the economy before bond yields fall even more and reduce its ability to do so. For another thing, it means that we shouldn’t be too surprised to see the bond market behaving oddly. Whether or not one can reasonably call it a bubble (and the term may not be entirely inappropriate), it is quite normal for the bond market to react strongly to disinflationary shocks when the yield is already low.

Disclosure: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Source: Bond Market Instability in a Liquidity Trap