22-05-2003 23:12									#1
	Bond Market during deflation Support Apolyton buy from Amazon

Ok, assume that there will be a sustained period of deflation in the US. You may or may not believe that that will happen, but just assume it. Will that be good for the bond market or will it cause a bubble to burst? If a bubble does burst in the bond market what will be result?

For those of you who are unfamiliar with the liquidity trap theory. It states that if interest rates continue to fall far they will reach a point where investors demand dollars instead of bonds.

There are a couple of articles at cnn.money on this today.



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	23-05-2003 04:28									#2
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ahhhh, the convexity trade!

	23-05-2003 04:39									#3
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quote: Originally posted by Sten Sture ahhhh, the convexity trade!

What does that mean Sten?

edit: no trick. honest. I would like to know what it means and I'm having trouble.

	23-05-2003 11:22									#4
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Fixed income traders are people who can calculate how much tips everyone at a table has to leave without a financial calculator.

	23-05-2003 13:48									#5
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Well, first thing is, with a deflation you end up with a nicely high real interest rate.

	23-05-2003 18:25									#6
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I prefer my interest rates shaken not stirred.

	23-05-2003 19:07									#7
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Deflation can be analysed as an addition to the interest rate.

Therefore, when deflation appears, without an equivalent decrease of the interest rate, the price of bonds should decrease.

If interests rates decrease when deflation appears, and in the same proportion, the price of bonds should not move.

If interest rates decrease more than the deflation, the price of bonds may increase.

When interest rates reach zero, bonds are no longer more attractive than notes or bank accounts (liquidity trap). This is particularly worrying for the Treasury which needs to issue huge amounts of bonds every year. To induce subscription, interest rates must remain positive. In other worlds, deflation will not reduce the burden of interests in the federal budget.

	23-05-2003 20:06									#8
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quote: Originally posted by Urban Ranger Well, first thing is, with a deflation you end up with a nicely high real interest rate.

joking? that's where the drag comes in.

	23-05-2003 20:12									#9
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quote: Originally posted by DAVOUT If interests rates decrease when deflation appears, and in the same proportion, the price of bonds should not move.

Is this possible to have negative nominal rates though? The nominal rates in Japan are still positive, but practically zero.

	23-05-2003 20:53									#10
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Although I can imagine a negative nominal rate, I cant see it applied in real life simply because the lender is better off in not lending.

	23-05-2003 20:59									#11
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quote: Originally posted by Kidicious joking? that's where the drag comes in.

UR is wright :

real interest rate = nominal rate - inflation or + deflation

With a nominal rate of zero and a deflation rate of 1%, the 100$ you had in the beginning of the year are still 100$ at the end, but meantime, the 100$ item costs now 99$. The remaining $ is equivalent to a real interest.

	23-05-2003 21:07									#12
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quote: Originally posted by DAVOUT UR is wright : real interest rate = nominal rate - inflation or + deflation With a nominal rate of zero and a deflation rate of 1%, the 100$ you had in the beginning of the year are still 100$ at the end, but meantime, the 100$ item costs now 99$. The remaining $ is equivalent to a real interest.

I know the rate is higher. That's the problem. The rate where S=I needs to be reached and that optimal rate is difficult to reach during sustained deflation. The only hope is for the central bank to convince investors that deflation will be reversed. The BOJ has given up. So there is no hope there. Hopefully we won't find out what will happen in the US.

	23-05-2003 21:18									#13
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You think that lowering the interest rates results infaillibly in improving the economy. The situation assumed in this thread demonstrates the limits of such a policy.

I believe, but I can prove it only in looking at the absence of effects of the last several decreases of the rate, that the monetary policy consisting in decreasing the rates has a range of effectiveness that we have largely exceeded.

	23-05-2003 21:22									#14
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quote: Originally posted by DAVOUT You think that lowering the interest rates results infaillibly in improving the economy. The situation assumed in this thread demonstrates the limits of such a policy. I believe, but I can prove it only in looking at the absence of effects of the last several decreases of the rate, that the monetary policy consisting in decreasing the rates has a range of effectiveness that we have largely exceeded.

I believe that liquidity traps are possible. In fact, I believe there is one in Japan. I think it would be very difficult to get out of one with monetary policy. However, I think that it is possible to avoid one with monetary policy. The Fed and ECB should act now, before it's too late.

	23-05-2003 21:24									#15
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What do you mean by : Fed and ECB should act ?

	23-05-2003 22:39									#16
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quote: Originally posted by DAVOUT What do you mean by : Fed and ECB should act ?

Monetary policy should be used to stop disinflation. If it continues investors will lose confidence in the central banks to control the situation. If that happens I think it will be too late.

	24-05-2003 03:40									#17
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I wouldn't worry about deflation too much. It takes a pervasive and pronounced deflationary move to be meaningful. Monetary policy should be sufficient to combat it, unless excess capacity isn't removed from the system... etc.


The convexity trade occurs in the bond market when mortgages are being refinanced in large amounts. Everybody who refinances effectively changes a 30yr bond with a 7 year average payment life, to cash. Inorder to offset the radical change in the duration of mortgage assets, long treasuries are usually purchased, driving down interest rates further - and making mortgages more likely to be refinanced. The amount of mortgage bonds in the bond index is 2x the amount of treasuries, so quick mortgage loan repayment can dramatically impact liquidity in treasuries.

Duration is the first derivative of the price-yield equation; convexity is the second derivative.

	24-05-2003 04:06									#18
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quote: Originally posted by Sten Sture The convexity trade occurs in the bond market when mortgages are being refinanced in large amounts. Everybody who refinances effectively changes a 30yr bond with a 7 year average payment life, to cash. Inorder to offset the radical change in the duration of mortgage assets, long treasuries are usually purchased, driving down interest rates further - and making mortgages more likely to be refinanced. The amount of mortgage bonds in the bond index is 2x the amount of treasuries, so quick mortgage loan repayment can dramatically impact liquidity in treasuries.

Does this lead to excess liquidity? That is, do people hold more cash? Can't they find some other investment for more value? Oh, and how does deflation and monetary policy play in to it?

Anyway, I will have to take that comfin course



Thanks Sten

	24-05-2003 15:01									#19
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What's comfin?

	24-05-2003 19:46									#20
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quote: Originally posted by Saras What's comfin?

A business finance course?

	24-05-2003 20:09									#22
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quote: Originally posted by Sten Sture I wouldn't worry about deflation too much. It takes a pervasive and pronounced deflationary move to be meaningful. Monetary policy should be sufficient to combat it, unless excess capacity isn't removed from the system... etc. The convexity trade occurs in the bond market when mortgages are being refinanced in large amounts. Everybody who refinances effectively changes a 30yr bond with a 7 year average payment life, to cash. Inorder to offset the radical change in the duration of mortgage assets, long treasuries are usually purchased, driving down interest rates further - and making mortgages more likely to be refinanced. The amount of mortgage bonds in the bond index is 2x the amount of treasuries, so quick mortgage loan repayment can dramatically impact liquidity in treasuries. Duration is the first derivative of the price-yield equation; convexity is the second derivative.

Could you explain that slower? I assume that the nature of the mortgage (allows refinancing) has an implicit risk for the lender, for which he should demand a slightly higher real rate. When a wave of refinancing occurs, it is just the banks taking a haircut.

	24-05-2003 20:12									#23
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quote: Originally posted by DAVOUT Deflation can be analysed as an addition to the interest rate.

ok.

quote: Therefore, when deflation appears, without an equivalent decrease of the interest rate, the price of bonds should decrease.

The reverse, no? Since the real yeild has increased.

quote: If interest rates decrease more than the deflation, the price of bonds may increase.

opposite, no?

	24-05-2003 20:15									#24
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Hey guys, I have Dunkan-Kid on ignore. Would I gain anything by looking at his posts?

	24-05-2003 20:20									#25
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Mmm... No, not really

	24-05-2003 20:23									#26
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quote: Originally posted by GP Hey guys, I have Dunkan-Kid on ignore. Would I gain anything by looking at his posts?

Well, for example you might know that DAVOUT was talking about the real interest rate instead of the nominal rate. What are you doing in here anyway? I started this thread. How are you going to know what we're talking about if you don't read my posts.

	24-05-2003 20:29									#27
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Ever heard of that stuff Shares? (I shorten it to corpfin...)

Does this lead to excess liquidity? That is, do people hold more cash? Not intentionally, but defacto because of the transactions occuring in the refi side of things, more cash is held temporarily as the old mbs (mortgage backed securities) are paid back and the new ones are issued. There is a peculiar time delay in the american mbs market of 15 or 25 days (FNMA and FHLMC are on different schedules) between the accrual period and the interest and principle payment dates. Somewhat similar to stocks going ex-dividend. If I own a 30yr FNMA 6% pool in April, then I know that refi's are going to be pretty high, but my payment doesn't come in until May 25th, so that cash is in transit between various intermediaries from the 1st or 5th or whenever the borrower closes on their new loan.

The number of securitized loans in the American mbs market is monsterous. Very few lending institutions retain their mortgage production, favoring the liquidity, and diversity of buying generic pools of loans from all around the country. What they do retain is the servicing of the loans that they make, which generally keeps about 50 basis points (0.50%) of the interest.

In a deflationary environment, you want as much duration (maturity adjusted for interest cash flow) as you can get in your portfolio, that is one reason we have seen bonds rally so much over the past couple of years. DAVOUT's first post was a little confusing in that regard. As nominal interest rates decline, bond prices go up, and go up a lot more as they get really low, because of their positive convexity. They get less cash flow the lower yields go, and their duration extends.

Deflation makes bonds extremely valuable, unless you are talking about large declines. 2% is not significant. Your fixed future cash flows will buy more goods in the future, while a stock represents declining cash flows since they are selling their products for less money.

	24-05-2003 20:32									#28
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quote: Originally posted by GP ok. The reverse, no? Since the real yeild has increased. opposite, no?

When the yield increases, a bond valued 100 before the increase will be valued less because investors are no longer willing to pay 100 to get only the previous rate.

Same thing, but reverse when the yield decreases.

	24-05-2003 20:32									#29
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This aint corpfin... its fixed income math, aint it? I once tried to comprehen a paper on MBS/ABS valuation and almost fainted

	24-05-2003 20:35									#30
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quote: Originally posted by GP Could you explain that slower? I assume that the nature of the mortgage (allows refinancing) has an implicit risk for the lender, for which he should demand a slightly higher real rate. When a wave of refinancing occurs, it is just the banks taking a haircut.

sorry. The banks do take a haircut, they own an asset - the servicing portfolio - that is in effect an interest only strip of the mortgage. Therefore when the bonds get refi-ed, if the servicing bank doesn't make the loans, their asset goes to ZERO. Ouch! The interest spread between funding and loan rates is about 80% this factor, not credit risk. Mortgages used to trade much tighter to treasuries before this instant no-cost refi business narrowed the refi trigger rate.

got the folks in town today; I'll be out for a while... cheers.