This post is contributed by StatsGuy, an occasional guest contributor and commenter.
Monday August 8 2011 witnessed a truly impressive financial spectacle—a natural experiment of the kind we see only once a century or so. The S&P downgraded US debt, and the price of US Treasuries skyrocketed.
Many pundits were left scratching their heads. Professional traders tripped over themselves trying to get out of the way. Macroeconomists at least had an explanation, arguing that the downgrade meant substantially lower growth, and this forced people to shift into Treasuries since bonds rise when growth projections diminish.
While some macroeconomists have an inkling of what is going on, I suspect they got their causation backwards. Why would an increase in a risk rating on debt directly lower growth projections? Usually, the increases in risk ratings cause increases in interest rates, and it’s the rate hikes that harm growth. But, um, nominal interest rates went down, right? Shouldn’t that have helped growth? More sophisticated economists will note that when they talk about rates, they mean the real rate (adjusted for inflation), and that if inflation expectations drop more than nominal interest rates, then real interest rates go up and this will slow growth. However, this did not happen—real interest rates actually declined about 0.2% along most of the yield curve between Monday the 8th and Tuesday the 9th. And if real rates declined, how would this cause lower growth? Instead, I suspect the decline in real rates was the outcome of lower expected growth. It’s all very circular and confusing, but at least I’m not alone. Others seem even more confused.
For example, Dick Bove said: “We have people buying Treasury securities because they’re worried about the Treasury. We’ve got people selling banks stocks, taking the cash and putting into the banks for safety. It doesn’t make sense. What you’re seeing is this adjustment is occurring and people are not sure how to react to this adjustment.”
While it all seems confusing, I would argue there’s a very simple explanation, and that people are behaving rationally. Money (and by extension, US debt), is a Giffen good. This is an argument I made to Scott Sumner in 2009 here and in emails. Recently Eric Falkenstein made it here. Simply, as the price goes up, consumption increases. This is because the income effect (people getting poorer) dominates the substitution effect (people want to shift to other assets). This is a pure microeconomic explanation of the drop in Treasury rates after the downgrade, and unlike the macroeconomic explanation does not require a circular argument with uncertain directionality in the causation. Let me explain . . .
Wealth, at the simplest level, is expected future consumption. Rational people try to preserve and increase future consumption (let’s pretend we’re all rational). Generally speaking, we have decreasing marginal returns to wealth. (The future consumption purchased by your billionth dollar isn’t as valuable to you as your thousandth dollar.) Wealth is volatile, and depends on the future state of the world and one’s current asset allocation. Specifically, it depends on future price uncertainty (inflation), expected asset price growth, and perceived asset risk.
Most models tend to treat money like a normal good. Thus, when price of money goes up (in terms of other goods and assets), people shift out of money and buy other assets. Likewise, when the risk of holding money increases, they shift assets out of money. I’m arguing here that in certain cases (e.g., in the presence of a deflationary environment) this does not happen because the utility of wealth is massively nonlinear. This non-linearity is ubiquitous. In finance, it takes the form of margin calls, bank covenants that require posting collateral, credit liquidations, and similar liquidity events. Among private actors, it takes the form of default threats on major debts (notably, home mortgages).
What effect does this nonlinearity have? Allow me to illustrate. Imagine Mr. Midd L. Class owns an asset portfolio that has as projected wealth profile as described in the picture below. The blue dashed line is his expected wealth trend line (the average return on investments). The dashed grey lines represent the upper and lower bounds for Mr. Midd L. Class’ wealth at any given point in time. The solid red line is a level at which his wealth MUST not decline below, lest he face a major liquidity event or possibly even a subsistence event. (All of this can be expressed mathematically, but the math doesn’t add anything to the argument.)
At the start of time, Mr. Midd L. Class has a typical investment portfolio, let’s say 40% stocks, 40% bonds, 10% cash, and 10% other. Each of these investments contributes to the expected return and to the variation in the return (which we will call risk). Let’s say one of these asset classes (the riskiest) suddenly loses value. This can be reflected by shifting the trend line down, as in Image 2:
Note that this asset allocation is no longer acceptable to Mr. Midd L. Class because at some point in the future he runs the risk of dropping below the red line. Likewise, imagine that the expected wealth path remained stable but there was a sudden increase in the perceived risk of the safest of his investments (which increases the perceived risk of the entire portfolio). This might look like Image 3 below:
In either case (decrease in current wealth or an increase in risk of safe assets), Mr. Midd L. Class will seek an alternative asset allocation that meets his criteria (maximizes expected future wealth without risking a negative liquidity event). This will generally be accomplished by shifting the balance of his portfolio from high risk/high yield assets to low risk/low yield assets—in other words, selling stocks and buying Treasuries. In the case of Image 2 (caused by a decrease in wealth, such as a stock market crash), this will force increased selling even if the average expected return on stocks becomes higher. In the case of Image 3 (caused by an increase in the default risk of bonds), Mr. Midd L. Class will shift assets away from his riskiest assets (stocks) to his least risky assets (bonds and cash), even though the cause of the problem was the increasing risk of bonds. In both cases, as the effective price of bonds increases (when price is measured using risk-adjusted return), Mr. Midd L. Class will actually buy more bonds.
The income effect derived from the risk of falling below the red line (where utility is highly non-linear) dominates the substitution effect (the incentive to shift to higher yielding assets). Mr. Midd L. Class’s expected wealth trajectory now looks like Image 4, low yielding but safe. Mr. Midd L. Class also probably responds by reducing his overall consumption (which at the aggregate level reduces overall demand).
Macroeconomists might observe that none of this is inconsistent with some macroeconomic models, and this is true. If everyone simultaneously experiences a wealth decline and shifts out of riskier (higher yielding) assets, this decreases investment in riskier high return enterprise, and growth slows. Slower growth means less expected future supply, and less expected future supply means less present demand . . . and the vicious circle we all know and love. Macroeconomics reinforces this dynamic, but the natural experiment we all observed when the S&P downgraded US debt shows that it’s not just macro- but also microeconomic behavior that explains much of the pro-cyclicality in highly leveraged capital markets. Without the presence of massive leverage, the macroeconomic problems would still exist, but the pro-cyclical microeconomic factors would at least be dampened. This pro-cyclicality augments macroeconomic risk, and creates a very real cost to using a massively leveraged credit-based monetary system.
The Baseline Scenario 
A very good point being that neither micro or macro economics can be viewed in a vacuum. The unfortunate point is that US politicians seem to only have knowledge of some micro and just about zero macro economics.
“as the price goes up, consumption increases.”
for T-bonds It’s exactly the opposite : consumptions increases so prices T-bunds prices goes up : it’s just product scarcity, not a Giffen product.
you explain nicely why someone would change allocation because of stocks falling, but T-bonds getting more expensive is a consequence, not a cause.
Nails it.
If wealth owners face a survival constraint such that there is some floor below which returns cannot fall with probability greater than epsilon, then an increase in risk will force them to shift to lower-risk assets, even if the increase in risk came from those same assets. In that precise sense, federal debt and other safe (or money-like) assets are a Giffen good.
You don’t mention it, but this is a very Minskyan argument. Except he would talk about cashflows rather than returns. In the specific case of margin calls returns are more relevant, but I think the cashflow version is more general. In any case the logic of the argument is the same.
You can also find arguments with a very similar spirit in the liquidity-constraint models of Jean Tirole and his coauthors.
I should add that it’s not necessary to the argument, and in fact rather misleading, to say that the purpose of wealth is to finance future consumption. It’s very hard to see how you get form that to the survival constraint (the red line), given that only a negligible share of wealth is owned by households that could plausibly face a subsistence event.As far as the argument of this post is concerned, the purpose of wealth is to finance future contractual cash commitments. This also makes it clear that the constraint typically operates at the level of banks or other intermediaries, not households.
I think this analysis is spot on. As an example, a couple of weeks ago, someone said to me she was afraid that the stock market would go down because of the reduction in GDP caused by the debt deal. In other words, she perceived an increased risk and her reaction was to sell that asset.
Couldn’t agree more with what you’ve presented here. I pulled out of some higher risk assets when I saw this coming a few weeks ago then bought them again when I felt they hit their low. It’s a shame how much government can affect these markets but it’s very important to recognize it.
For gods’ sakes, nobody with brains and common sense thought the S&P downgrade of T debt was *substantively* credible or important. It wasn’t based on any new info or new insights from existing data.
What the downgrade did amount to, was another political bumper sticker talking point to dampen US government spending, and that is substantive in its effect, and was good for T bond prices.
The argument that the downgrade increases the probability of austerity, thereby lowering growth and lowering the relative return on equities and other risky assets, could well be true too. There’s no conflict between that and the argument of this post.
rates fell because of the q1 growth revision and q2 disappointment. if the US was not obsessed with the deficit this would be obvious.
The downgrade also cast additional doubt on Washington’s willingness to extend its balance sheet once again to rescue its wards on Wall Street (i.e. the banks), should that be necessary.
(I’d say ability and/or willingness, but the ability is not really in doubt, not as long as the Fed owns a printing press).
In other words, the politicians may not be any more likely than they’ve ever been to default on Uncle Sam’s obligations, but may be marginally more willing to let others default on theirs — which could easily create one hell of a “subsistance event” for a lot of leveraged players.
These explanations — Giffin goods, rational economic expectations, worries about future “Minsky moments” — are all consistent and all point in the same direction, which may explain the tear-your-face-off intensity of last week’s event.
I disagree with this analysis. Investors seek to maximize returns and minimize risks, two sometimes incompatible objectives, whose potential for conflict cannot be simply ignored by suggesting they seek to maximize risk-adjusted returns. At times the conflict between these two objectives results in strange phenomena like the remarkably low bond yields.
When the US fiscal outlook deteriorates, investors’ concerns about risk increase. They therefore rationally shift their portfolio toward less risky asset classes – e.g. US government bonds. This flight to safety effect overwhelms any reduction in expected returns from the credit downgrade. Ironically, when concerns about the most safe asset triggers a flight to safety, the price of that most safe asset will go up rather than down, despite its deteriorating fundamentals.
I don’t think this is a totally bad post. There is some logic. But I think StatsGuy’s post contradicts itself in some ways. I would say my main complaint with this post is it seems to imply the main factor causing lower rates is people running from stocks to bonds. Here are some points I could put in one paragraph, but I think it’s better grasped in bullet style:
—–I don’t think people running from stocks to bonds is the main factor driving rates down. Most people are not going to yank their money out of a 401k, even if they see the market going down to the end 0f 2011.
—–I think the main factor driving rates down is money market funds running to Treasuries. I think hedge funds for the very wealthy and huge investment firms like Blackstone have effected Treasury rates (i.e. short-term demand for Treasuries) much more than the average individual investor.
—–Also, when you look at the problems with Bank of America, JP Morgan etc, it’s not too hard to imagine people might even take money out of their bank account and put it into short-term Treasuries. If you believe Treasuries are that “dangerous” (I don’t), you would choose short-term Treasuries over long-term Treasuries.
Bottom line: Most people know this S&P “downgrade” (which looks more like a downgrade on the credit agencies criminal racket) means absolutely nothing, and is a puppet show orchestrated by someone who has a lot of poker chips bet on a 2012 Republican victory. It may work…… I can no longer predict the inclinations of a country largely composed of illiterates watching “Reality TV”, even if it is my native country.
Why make it any more complex than the fact that the market saw the downgrade as increasing the likelihood of a new recession because, as a NYTimes article proclaimed, the deficit committee would now have more of a mandate and redouble it’s efforts to cut spending? And of course, the downgrade had zero actual validity when it came to the integrity of treasuries, so it was just disregarded as an indicator of bond values.
Some notes to thoughtful comments:
– In talking about “price”, it’s important to think in terms of risk adjusted returns. In that sense, holding everything equal, the value of a 3% bond decreased because the risk increased. The price of the bond should have dropped to match the value. Instead, price moved up (rate moved down).
– It is unlikely that expectations of increased austerity drove rates down. Prior to the S&P downgrade, the markets expected the budget reduction plan to come in at 2.6 to 4 trillion in cuts. The 2.1 to 2.3 trillion in cuts actually proposed (many of which were already resulting from military drawdowns) were below expectations, and the market did not react favorably. There was no clarity that the S&P downgrade would cause Congress to take the issue back up and enter another round of negotiations.
– If reduction in expected growth was the cause of the rate fall, then what was the mechanism? Traditionally, when risk of a bond increases, rates rise, and it’s the expectation of higher rates that cuts growth. However, here rates fell, and when rates fall (holding everything else equal), this should increase growth expectation. One note, btw, is that rates on riskier private bonds did go up.
– The giffen goods mechanism is consistent, and moves in the same direction, as the macroeconomic mechanisms. Which is “very bad”. Traditional understanding of asset allocation theory suggests that private asset allocation should move against the macroeconomic factors. In other words, if money/treasury debt was a normal good, then the substitution effect would dominate, and we’d see a move into stocks.
The general point is that under conditions of severe leverage and massively non-linear utility on returns (due to liquidity events), the underlying assumptions in traditional monetary models are plain wrong. The classic Merton/Markowitz asset allocation model fails.
I don’t expect anyone to take my word, but if you read through some of the post-event analysis, you see the pattern emerge:
http://blogs.reuters.com/macroscope/2011/08/06/wall-st-downplays-downgrade-will-markets-listen/
“One of the problems that everyone is worried about with a downgrade is there is a lot of investment guidelines where you are forced to maintain certain credit quality, and if you are bumping up against it, all of a sudden you are going to fall below your guidelines, so that means you probably have to buy more Treasuries and probably sell corporate debt or something like that.”
Clearly, it’s not just small private investors that are affected. Large institutional investors are directly affected, and may not have any choice in the matter. If they have to maintain a certain average grade on assets, if their best assets fall in grade, they are forced to actually sell their worst graded (riskiest) assets.
thank you for comments
Mozes Herzog writes: “I don’t think people running from stocks to bonds is the main factor driving rates down. Most people are not going to yank their money out of a 401k, even if they see the market going down to the end 0f 2011.”
Most 401(k) plans offer a menu of domestic equity, international equity, money market, and bond funds.
The Investment Company Institute’s stats show mutual fund investors moving money from domestic equity funds to bond funds at a steadily accelerating pace.
Weekly Flows of Long-Term Funds
Excellent post. However, although your argument is sound and enjoyable I wouldn’t go so far as to say money is a Giffen good. It’s my understanding (and it is limited to say the least) that to be a Giffen good price is the only thing that changes in order to get a change in quantity demanded. Your argument lists other factors which contribute to the phenomena you detail. If so these would preclude money from being listed as a Giffen good.
Interesting analysis. Though admittedly, a little beyond my appreciation.
I’m inclined to view the whole week as another reason why the US should impose a modest tax on trading. Would such a tax dampen this kind of response? Perhaps, perhaps not, but it would at least capture some revenue – maybe pay for a few a days of food stamps for Mr Low L. Class.
kc
@jm
I hope people will click on that link you gave jm.
First of all, the link you gave doesn’t clarify how much of those mutual fund equity outflows are from 401k. You do know that many people hold massive amounts of mutual funds outside of 401(k)s??? So a massive amount of those mutual fund flows are most likely not from 401(k)s.
Secondly, the chart you gave shows consecutive lowering of inflows in bonds, and even outflows from bonds in all/each of the 5 weeks of the chart.
Now, jm, how are you concluding that falling inflows and even outflows from bonds equates to people transferring money from equities to bonds in their 401(k)??? The chart you gave shows bond inflows falling and even bond outflows, and doesn’t clarify how many of the equity outflows are from 401(k), or even where those equity outflows are going.
None of this chart you gave, jm, even accounts for the money flows not kept in mutual funds, which would include ROTH accounts at brokerages. You know—the people who don’t want strangers and fee gougers deciding where their retirement money is invested—that’s probably a strange concept for people who can’t read a chart jm, but I’m taking a leap of faith that you’ll get that concept.
‘(All of this can be expressed mathematically, but the math doesn’t add anything to the argument.)’
Just wondering if you could provide me with a link to the math? I’d be interested to see the models.
A well written article that helped clearly explain the concept behind a Giffen good and how it would apply to the relative allocation of stocks and bonds. The conceptual idea of a good having an absolute and/or relative increase in price even as the value of the good decreases makes sense. What I have not heard an explanation for is why the market appears to still value US Treasuries more than other safe bonds.
If investors only had one choice for safe investments the Giffen good argument would seem to hold, but since investors could also diversify within the same investment class by purchasing high rated corporate debt or sovereign debt. Unless the argument is that the downgrade of US debt is seen as a downgrade of world debt (and therefore US debt still has the highest value by virtue of all debt decreasing in value) then US debt should be relatively riskier than other safe debt. If this was not a downgrade of world debt shouldn’t we expect to see US bond yields rise relative to AAA rated sovereign and corporate debt? If so, this does not match with real world results.
Highly rated corporate and sovereign debt did increase in price from August 5th through August 9th but significantly smaller than the increase in US Treasury prices. If US debt is still considered the safest debt (in relative terms) then why would a downgrade that implies US debt is less safe than German or Finnish debt be considered new and important information?
I think it is a very interesting idea that you have but I am having a hard time understanding how these issues are reconciled.
I think the point being if the Dutch and Germans had to purchase the debt, then they would want a different form of thinking in order to satisfy the creditors that their thought process is clear. Which currently it is not and should no else step up to the plate there is very little appitite for the same recipe as 2008. The landing looks soft until you take the net away, after that, you just hope you wake up before you hit the dirt.
“The conceptual idea of a good having an absolute and/or relative increase in price even as the value of the good decreases makes sense”
and you wonder why issues aren’t reconciled?
So people moved from higher-risk higher-yielding stocks to lower-risk lower-yielding Treasuries. But… the point was to explain WHY an increase in risk for Treasuries would move people into buying even more Treasuries. Your explanation then only works if increased Treasuries risk somehow implies an even greater stocks risk. Is this assumption correct? Is this what you meant?
The market crashed and there was a flight to safety. Safety = cash. Cash = Treasuries.
The price of a car is based in some ways on quality. A car from 1930 is nothing like a car from today – even is compared by inflation.
The “price” of treasuries is based on the return. When people are willing to pay today prices and get a car from the 1930’s in quality, that is them being willing to take a loss.
It is a convenience tax on storehouse of value, it may have a price level attached to it, but the function of money here is storing value.
And all of this is find and dandy – except that the REQUIREMENT that fund managers have to find returns forces them to take riskier positions, to make up for the lack of safe returns.
This increases anxiety.
I actually think it is a good thing. It reminds me of natural money. You can’t get interest returns on a safe loan, so you are forced into deeper and deeper equity positions.
Statsguy, your model doesn’t seem to include cash as a possibility. Investors who are facing an extinction event could move to cash and dump both stocks and T-Bonds. So the latter two prices should fall in a T-bond downgrade.