Thursday, 8 March 2012

Bond Yields and Saving Behaviour in the US

What relationship, if any, consistently holds between interest rates and private savings behaviour? Do savings really go up when interest rates go up? And can excessively high savings ratios be brought down by keeping interest rates low? If so, what rates, and how low? And if savings rates stay high regardless does that mean we're in some sort of liquidity trap?

I should probably have had this down decades ago when I first encountered an ISLM graph, but the truth is that I've never met anyone in the market who actually uses ISLM analysis. Or mentions it.

Instead I have focussed on private cashflows and savings behaviour, usually looking at private sector savings surpluses and tracking their impact on bond yields. For emerging markets, this is often crucial: the most powerful financial dynamic bar none in emerging markets is what happens to government bond yields when a private sector savings deficit flips over into a surplus, or vice versa. In these cases, the cashflows are easy to trace: if an economy develops a savings surplus, then on a net basis, the private sector is dumping cash into a financial sector which, by definition, can use it to buy only government bonds or foreign assets. Hence bond prices rise and yields fall. Easy money.

Even in the massively-open and highly disintermediated financial system of the US, traces of the relationship remain.

Interesting though this is, it's hardly a complete theory linking bond yields with savings behaviour. Nor would one expect it to be: if private sector savings surpluses and deficits were the only determinant of bond yields, the world wouldn't have so many fixed income economists (and professional Fed watchers). And the financial world would never had heard of 'fair value models' for bond yields.

So let's look at those models. In my experience these fair value models regress and regularly recalibrate from three factors:
  • policy rates
  • inflation rates
  • growth rates
A movement, or an expected/forecast movement in any one of these will change what the model signals to be the 'fair value' of a bond.

Anything that regresses and recalibrates enough will end up looking like it has useful explanatory power. Here's how my simple fair-value model of US bond yields compares with what actually happened over the last 21 years. It's not a superb fit, and even if it was, that would be testament simply to the power of serial recalibration rather than the theory it allegedly sets out to test.
Nonetheless, the conclusions which we can draw from this model are remarkably similar to those wrested from doubtless far more sophisticated models produced by our august Wall Street friends. And so are the conclusions are drawn by comparing actual bond yields with 'fair value' yields. What screams out in retrospect is that during 2004-2008 bond yields were far lower than 'fair value'. And from there it is but a step to conclude that the chief reason for that was that policy rates were set too low for too long, and, moreover, were expected to be kept too low for longer still. The graph serves as the charge-sheet against Alan Greenspan. And as it looks as if the same thing is happening again now (bond yields far lower than 'justified' by likely economic growth and inflation), we might eventually find it thrown into evidence against Ben Bernanke at some later date.

What the chart is saying right now is simple: bond yields are simply too low, making bonds an unattractive investment. Let's put it even more bluntly: who in their right minds would save to invest in bonds right now? At which point, we get to ask (and answer) an important question – regardless of the absolute nominal bond yield, does sufficiently 'bad value' in bond yields usually dissuade saving, and do sufficiently 'generous' bond yields usually encourage saving?

And I think we can answer than question empirically with a simple 'Yes'.

Consider the relationship between the deviation of bond yields from fair-value, and movements in the private sector savings surplus. The chart below illustrates it well, and that's not just because I've fiddled the axes. More importantly, the correlation between sequential movements in these two during the last 87 observations passes the 1% significance level quite easily.
For those of us interested in recent US economic history, and in global savings/investment imbalances, this chart is pretty irresistible, as it links the descent into major private sector savings deficit during 1997-2000 and again in 2005-2007 with bond yields being somehow maintained at levels which actively discouraged saving. When yields rose (relative to 'fair value') savings deficits were trimmed and reversed.

And now? Bonds represent absolutely rotten value, and as long as this is the case, the US private sector savings surplus will continue to decline, boosting US consumer demand at a pace slightly exceeding those of private sector income growth (widely defined).

One more thing: there is absolutely no sign of a Keynesian 'liquidity trap' anywhere on this chart.

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