Higher Bond Yields Suggest Abenomics Is Working (But Only A Little)

Includes: EWJ
by: Scott Sumner

Tyler Cowen recently linked to a FT piece that contains some great examples what goes wrong when one reasons from a price change:

It illustrates the natural tension that occurs when central banks seek to push investors out of government bonds into equities and other asset classes. The risk is that such an effort can quickly become counter-productive as bond investors dump their holdings and look for higher returns elsewhere.

Rising equity and real estate prices boost wealth, consumer confidence and overall economic activity, but there is a risk that higher government bond yields can weigh on the economy.

That's pretty much a textbook example of how "reasoning from a price change" leads one to make fundamental errors. The rising rates don't "weigh" on the economy; they are a sign of faster NGDP growth expectations. The FT confuses cause and effect.

In the US, the Federal Reserve's initial rounds of quantitative easing pushed Treasury yields upwards, resulting in economic soft patches in 2010 and 2011.

That's simply false. Rates fell during the "soft patches."

At the same time, rising interest rates could undermine the government's attempts to improve its own finances, precipitating a fiscal crisis.

More reasoning from a price change. The rates are rising from expansionary monetary policy, which creates expectations of inflation (or slower deflation.) And, of course, inflation helps debtors. Japan's government is the world's second largest debtor. The fallacy is to confuse nominal interest rates, which may indeed rise, with real interest rates. Inflation reduces the value of existing debt, which helps the Japanese government, and for new debt it's a wash, as higher nominal rates reflect the Fisher effect.

Yes, the gains may be reduced if the Japanese government must bail out a few banks that suffer losses on their JGB portfolio, but at worst it's a wash. And the real growth generated will help both the government and the banks.

It's not a zero-sum game!

BTW, this seems wrong:

"Through dialogue with the market and more flexible operations, we will ensure the stability of financial and capital markets," Mr Kuroda told a seminar in Tokyo on Friday.

His comments came as the BoJ stepped into the market to buy bonds for a second consecutive day. On Thursday, as fears over rising bond yields sparked a 7.3 per cent fall in the Nikkei 225 stock index, the BoJ was forced to supply Y2tn ($20bn) of funds to nervous investors.

The graphs I've seen recently show a positive correlation between stock prices and bond yields in recent weeks. Both rose over a period of weeks, and then both fell on Thursday. Is that wrong? Higher bond yields suggest faster NGDP growth is on the way. Unfortunately rates are still quite low, which indicates that NGDP growth will probably increase only modestly. The BOJ needs to do much more.

Update: Here's Lars Christensen:

Yes, nominal bond yields are rising – as Friedman and every living Market Monetarist said they would. However, real bond yields have collapsed since the introduction of Japan's new monetary regime as inflation expectations have picked up. Something Mr. Koo for years has denied the Bank of Japan would be able to do.

Isn't Koo the guy that claimed Japan was stuck in a liquidity trap? How would he explain the recent plunge in the yen?

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