Macromania vs Bill Gross

Think about it. A USD is the equivalent of a zero-interest-bearing small denomination Treasury bill. So when the Fed is purchasing longer dated Treasuries, what is it doing? It is selling zero-interest bills for (slightly) positive-interest bills. Would a deceleration in this asset-swap activity really have the dramatic effect Gross suggests? (He is suggesting a sharp spike in Treasury yields). I doubt it. In fact, the implied tightening is likely to keep a lid on inflation.

This is David Andolfatto in a virtual debate with Bill Gross, the "Bond King". The issue here is how much effect is the Fed having on the bond market, in terms of keeping the curve sliightly flatter than normal so Congress can get through its budget cycle.

Under a minimum variance assumption, David assumes there is a smooth partion of bond buyers who will move over and marginally allow long term rates to nudge marginally higher. Bill Gross looks at a finite distribution of buyers, a countable set of large bond buyers, and thinks the next partition of bond buyers will be substantially smaller. Hence Bill believes we have a sharp jump in long term rates.

Who is right?

Well let's add in government to the model, they are the sellers of bonds. What is their current budget cycle? Two weeks, the length of the continuing resolution. So currently, Congress is functioning because the Senate is willing to put in a full two weeks per cycle managing the budget. What is the marginal speed up of the cycle if Ben quits the game. Maybe twelve days, if the next set of bond buyers are kind. But the next set of bond buyers are mostly foreign, and far away, in a more difficult position to measure Congressional risk. The more likely budget cycle for the Senate becomes on the order of ten days. There is a discrete jump down to the next transaction rate, not a smooth jump. Congress is on a short leash.

I go with Bill here, foreign bond buyers are going to be very suspicious that my Senator, Babs Boxer, can manage a budgeting cycle like that. Foreign bond buyers will demand a higher interest rate and a longer budgeting cycle. They are going to want continuing resolutions of a month or so.