11 Nov 2009

Bond Buccaneer Bleg: Murphy vs. Sumner

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Do any of the esteemed Free Advice readers have experience with the bond market? I don’t mean, “Did you know that price and yield move in opposite directions?” I mean, do you really understand bond math etc.?

I ask because Scott Sumner and I are launching volleys at each other (he from his ivory tower, me from my armchair), and we’re stuck on a fairly crucial point. Here he gives a lengthy rebuttal (or it might be a rejoinder at this point, I’ve lost track) to my response to his “Does Macro Need a New Paradigm?” post.

(BTW I am having trouble logging on to Free Advice this morning. Is it because I’m getting mad hits from Sumner’s link? I don’t know whether to hope for that or not. I.e. I’m going to be annoyed if I start to hit the big time and learn that my host can’t handle it.)

Anyway one of the key issues is that Sumner claims the massive spike in the TIPS yield (in fall 2008) could be due to a collapse in inflation expectations. I thought “no way!” because by definition the TIPS yields aren’t supposed to be affected by price inflation concerns.

Scott said yes that’s true for newly issued TIPS, but for “off the run” TIPS there would already have been a significant amount of pent up CPI hikes, which would then unwind (as it were) if investors expected the CPI to fall drastically from 2008 – 2010 let’s say.

I thought that at best this effect would just cause a one-shot adjustment in the market price of older TIPS, so that the yield-to-maturity would be basically the same for older or newer TIPS. To bolster my case, I emailed Scott this graph, showing a 10-year TIPS and a 5-year TIPS, that both mature within 3 months of each other in early 2011. As you can see from the link, their yields were virtually identical on the way up, and then diverged only slightly coming back down.

Scott said that the picture is consistent with his thesis.

Thus we’re once again stuck. Like all good economists, Scott and I can look at the same chart and say, “Yep, just like I predicted”–even though we totally disagree with each other.

Any help? Anyone?

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