John Cochrane - Spring 2013

7/30/2019 John Cochrane - Spring 2013

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The Interest Rate Paradox

John H. CochraneUniversity of Chicago Booth School of Business,

Hoover institution, Cato institute,

http://faculty.chicagobooth.edu/john.cochrane

The Grumpy Economist blog

Johnhcochrane.blogspot.com
http://faculty.chicagobooth.edu/john.cochranehttp://faculty.chicagobooth.edu/john.cochrane


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1960 1970 1980 1990 2000 20100

2

4

6

8

10

12

14

16Treasury yields

10yr

5yr

1yr3mo

Constant-maturity treasury yields and 3 month rate. Source: Fred


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1990 1995 2000 2005 20100

1

2

3

4

5

6

7

8

9

10Treasury yields

10yr

5yr

1yr

3mo


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1960 1970 1980 1990 2000 20100

2

4

6

8

10

12

CPI inflation

Core CPI inflation (ex food and energy). Source: Fred


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Revenue: $2.5TExpense: $3.5T

Debt: $16T

Promises:Gazillions


6/25

Source: http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htmhttp://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm


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Growth (or not) drives deficits

Tax revenue = tax rate x income


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2010 2015 2020 2025 2030 2035 2040 2045 2050

0

5

10

15

20

25

30

35

40

Revenue

Spending

Deficit

PercentofG

DP

CBO Long Term Budget Outlook


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2010 2015 2020 2025 2030 2035 2040 2045 20500

5

10

15

20

25

30

35

40

Revenue

Spending

+1% Growth

+2% GrowthDeficit

+1% Growth

+2% Growth

PercentofGDP

The Effect of Economic Growth on Deficits


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$1,000

$1,200

$1,000

$1,200

Bad news (or rumor!)

Financial crises are always and everywhere

the result of short term debt

Bankrupt!

Default/inflate

Pay back?

Default/inflate?Long term debt

Short term debt

Short term debt: Future problems cause crisis today


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2015 2020 2025 2030 2035 20400

10

20

30

40

50

60

70

80

90

100

Year

Percent

Fraction of debt coming due before each date

Treasury

With Fed


12/25

But even the CBOs dire forecast assumes a

return to growth! (and magical spending cuts)

http://cbo.gov/sites/default/files/cbofiles/attachments/43907-BudgetOutlook.pdf


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2010 2015 2020 2025 2030 2035 2040 2045 20500

5

10

15

20

25

30

35

40

Revenue

Spending

Deficit

-1% Growth

PercentofGDP

The Effect of Slower Growth on Deficits


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1960 1970 1980 1990 2000 20100

2

4

6

8

10

12

CPI inflation


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1990 1995 2000 2005 20100

1

2

3

4

5

6

7

8

9

10Treasury yields

10yr

5yr

1yr

3mo


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1960 1970 1980 1990 2000 20100

2

4

6

8

10

12

14

16Treasury yields

10yr

5yr

1yr

3mo

Constant-maturity treasury yields and 3 month rate. Source: Fred


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2010 2015 2020 2025 2030 2035 2040 20450

0.5

1

1.5

2

2.5

3

3.5

4

4.5Treasury Yield Curve

Forward

Yield

Zero-coupon yield curve 4/2/2013 . Source: Gurkanyak, Sack and Wright (FRB)


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2010 2015 2020 2025 2030 2035 2040 2045 20500

1

2

3

4

5

6

4/2/2013 curve

4/2/2010 curve

Treasury Curve

Forward

Yield

?


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1960 1970 1980 1990 2000 20100

2

4

6

8

10

12

14

16Treasury yields

10yr

5yr

1yr

3mo

S i


20/25

Scenarios Consensus. Economy improves slowly, slow tightening inflation

anchored. Enough entitlement reform to stop a crisis.

Japan. 10-20 year stagnation, inflation to zero, rates stay zero,great time to hold long term bonds. Debt builds up to magical

levels (200%+ GDP)

Mild crisis. Inflation to 3-4%, Fed tries to tighten, cant from

fiscal / bank/ political limits, stagflation breaks out.

Severe crisis 1: Rates rise, debt spiral

Severe crisis 2: Europe, state bankruptcy, etc. trigger run on

long sovereign debt then run on dollar.

Miracle of common sense: Tax reform, entitlement reform,

structural reform, return to strong growth, pay off debt, inflationstays low.

Forward curve: Averages all these + risk premiums.

What to do: Wise portfolio allocation starts with risk

managementnot alpha.


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The End


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$1,000

Investment

$1,500 Revenue

$1,200 Debt

$300 profit

$1,000

Investment

$1,500 Revenue

$1,100 Debt

$300 profit

The attraction of short-term debt


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$1,000

Investment

$1,500 Revenue??

$1,200 Debt

$300 profit??

$1,000

Investment

$1,100 Debt

Bad news (or rumor!)

$1,500 Revenue??

Financial crises are always and everywhere

the result of short term debt

Bankrupt!

Documents

John Cochrane - Spring 2013