James Carville once said:

“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

Carville was very close to getting this right.  The only problem is, he fell for the old bond vigilante belief.   What Carville should have said was this:

“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the Federal Reserve. You can intimidate everybody.”

I’ve spent a great deal of time trying to debunk the idea that bond markets will one day revolt and cause the Fed to raise rates which will appear like bond vigilante justice.  Many market commentators have used the European crisis to prove this point.  But of course, the EMU is made up of currency users and not currency issuers.  There is a very real solvency constraint in each EMU country that adds a layer of risk to their bond markets.  Bondholders know this and it causes a vastly different dynamic than it does in a country like the USA or Japan where the government is a supplier of its currency in a floating exchange rate system.

To illustrate this point I ran a few correlations across the yield curve in the USA.  I took various durations and found the correlation between the monthly movements going back 40 years (less so in the case of the 30 year) and the Fed Funds Rate.  What I found surprised even me.  The data shows a remarkable correlation even at the long end of the curve.  Naturally, the Fed controls the Fed Fund’s Rate, but as we went out on the curve the correlations remained very tight (FFR at 100%, 3 month at 97%, 1 year at 96%, 5 year at 91%, 10 year at 86%, 30 year at 87%).  Even at the longest duration there is an 87% correlation between the movements of the Fed Funds Rate and the 30 year bond.  In other words, the bond market is the Fed’s whipping boy.  Not the other way around.


What’s interesting in this data is that the bond market is taking its cues almost entirely from the Fed.  The market, as one might assume, actually wields very little control over the long end of the curve.  This isn’t entirely surprising as long rates are really just an extension of short rates.  But it is somewhat surprising to see the incredibly high level of correlation that we’ve found here.

What’s more interesting is that there appears to be no worry of solvency in this data.  The last few weeks have been particularly interesting.  Even as a default risk loomed the bond market appeared to be whistling past the graveyard.  I have argued that there is no solvency constraint for a nation that issues its own currency in a floating exchange rate system.  But the bond market clearly doesn’t adhere to the beliefs of me.   What it does adhere to, however, is the beliefs of the Fed.  And the Fed’s message has been very clear in recent weeks:

1)  The US government should absolutely not be allowed to default.  Ben Bernanke made this abundantly clear in a speech several weeks ago.

2)  The economy is weakening.

To bond investors these messages from the Fed are like siren calls to buy bonds as they perceive the Fed’s accommodative policy as being a near certainty in the coming months.   As we see above, the easy Fed means the long end of the curve should remain a decent bet.  Bondholders are putting their money where the Fed’s mouth is.

The bottom line here – the old adage “don’t fight the Fed” should be plastered in the hallways of every bond trading desk in the world.  And when I come back I want to come back as the Federal Reserve.  Then I can intimidate everybody.

Addendum – Several readers have listed concerns such as the fact that the 3 month t-bill appears to lead the Fed Funds Rate or that the correlations further out on the curve could be backward, ie, the long bond market actually leads the Fed.

First, I would note that we should expect to see the bond market lead the Fed Funds Rate to some degree in real-time.  That is because the Fed always tries to influence market expectations via their announcements.  In fact, this is always their intended goal via FOMC announcements.  A good example of this was QE2 where Ben Bernanke announced the program several months before it actually started.  These sorts of communications are intended to help the markets absorb these important changes in monetary policy well in advance of the actual changes.

As for the potential that I am datamining the correlation and reading it backwards – I would note that the correlation does indeed decline as we move further out on the curve.  This is similar to the effect we would expect to see if you laid a very heavy fire hose on the ground and attempted to cause a ripple through the entire hose by shaking it up and down at one end.  Clearly, the effects would be entirely controlled at the end nearest to your hands and the effect of the shaking would become gradually reduced as we moved further away on the hose.  The impact in the market is somewhat similar.  Clearly, based on this data, the effect on the long end is somewhat smaller than the effect at the ends closest to the Fed Funds Rate.  One could view this as the Fed having marginally less control over the long-end, but still controlling the curve (as is clear from the still high correlation of 87% at the 30 year).


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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    Cullen- How can Bill Gross totally miss this concept?
    He has been waking up every morning heading to the town square with his box in hand. Climbing on top of it and exciting the vigilantes to revolt and sell their U.S bonds to demand higher rates on this asset.

    Maybe you should show up to one of his Yoga classes and during his tantras you can expell MMT mixed into this chants. I think this is his best hope of being saved

  • MS

    Interesting result. Your r squared values show the relative significance of the fed vs. market (random?) factors, but I’d be interested to understand the linearity of the correlation. did you run a linear regression, or a polynomical or log regression?

  • Cowpoke

    Nice work and graph, thanks C.R.

  • pistol495


    Great article. Was waiting for some clarification on this exact subject. Those correlation numbers are astounding.

    Read your stuff every day – you are first rate. Incidentally I grew up in the DC area myself. You go to high school in the area?



    could it be the Fed front-running bond vigilantes? They do have access to lot of researchers and data. chicken and egg ?

  • DontFightTheFed

    Thanks for the laugh. Just imagining Bill Gross in a yoga class listening to MMT chants made my day. We should also include MMT fragrance joss sticks to create the ambiance.

  • beowulf

    “could it be the Fed front-running bond vigilantes? They do have access to lot of researchers and data. chicken and egg ?”

    Seriously? With correlations of 87& to 97%? That’s not chicken and egg, that’s chicken and time machine. Arguing against the time traveler option is that apparently the Fed’s predictive powers are limited to the Treasuries market and don’t extend to the oil, real estate, stock or employment markets.

  • MMTer

    If you had the math and the fancy credentials to back up your work you’d win a Nobel.

  • Odysseus

    “To bond investors these messages from the Fed are like siren calls to buy bonds as they perceive the Fed’s accommodative policy as being a near certainty in the coming months.”

    … and then be killed? Thats what those sirens did, after all. ;)

  • Albatross

    CR: What do you make of these QE3 pronouncements?

    1. What it will take for the Fed to launch QE3?
    2. What form will it take?
    3. Will it work?


  • Different Chris has a stupid question

    How do I get a picture to accompany my moniker?

  • Different Chris

    “That’s not chicken and egg, that’s chicken and time machine”

    Absolutely Brilliant

  • Anthony T

    But isn’t the Fed itself intimidated by the politicians? Many economists have come out and said that the Fed can inflate us out of this slump by raising expectations to something like 6% inflation for 2 years or 4% for 5 years. But when pols are screaming to “stop and desist” after something benign like QE2, Bernanke suddenly forgets everything he read about the Great Depression and Japan.

  • Rharaz

    A blog at http://jazzbumpa.blogspot.com/2011/05/who-determines-short-term-interest.html conjectures that “The Federal Funds Rate, which is set by the Fed, FOLLOWS 3 month T-Bill rates. It does not lead the economy.” Is his argument sound? Thanks.

  • prescient11

    What a great chart cullen, thank you.

  • LVG

    I think that 3% variance in the 3 month rate in Cullen’s data is due to the fact that the market anticipates the Fed’s moves. The fact that the market begins to move in anticipation of the Fed’s actions is exactly what the Fed would want and it would be due to their commentary in all likelihood.

  • http://marketthoughtsandanalysis.blogspot.com/ binve

    Excellent study! Thanks for sharing this!

  • http://www.pragcap.com Cullen Roche

    No, Paul Krugman already made it clear that my opinion doesn’t matter because I don’t have a PhD!

  • http://www.pragcap.com Cullen Roche

    Exactly what we’d expect to hear from a bunch of old Fed economists. If we keep throwing more shit against the wall it might eventually stick. The problem with monetary policy is that it mainly works through the banking system and the lending channels. There’s no demand for loans now because the aggregate debt levels are still too high. So, Fed policy is going to remain a very poor tool to combat this recession.

  • beowulf

    So much for his recent post titled “Listening to Others”. :o)

    I agree with Mark Thoma that economists really need to listen to people outside their circle. Many years ago, when I wrote about doing economics, one of my principles was “Listen to the Gentiles”, meaning listen to intelligent people, even if they don’t speak your analytical language.

  • beowulf

    The problem can be summed up in a sentence. There is a old map maker from St. Louis named Larry Meyer that everybody believes implicitly nobody how often he’s wrong because his maps are always packed full of interesting data and yet are careful to always keep the FIRE sector hidden so as not to confuse the easily confused.

    The national model discussed here is the ‘Washington University Macro Model’ (WUMM) used in US policy making… a quarterly econometric system of roughly 600 variables, 410 equations, and 165 exogenous variables… In contrast to accounting models, the financial sector is thus absent (not explicitly modelled) in the model… by design, it cannot reflect a bubble driven by credit flows to the FIRE sector, which bursts due to excessive levels of debt: credit flows, the FIRE sector and debt are not among the variables in the model, nor are they fully reflected in the variables which are included… The Macroeconomic Advisers approach also reflects the official US viewpoint on financial stability as its founder Laurence Meyer… [who] represented the Federal Reserve Board in the international Financial Stability Forum p. 19, 24. Great paper, the hero of the story is Wynne Godley.

  • Peter D

    When did say that, Cullen?

  • http://www.pragcap.com Cullen Roche

    I am actually wrong. I went back and looked and it was not Krugman who said it, but a bunch of his supporters. Poor form on my part….


  • Peter D
  • http://www.pragcap.com Cullen Roche

    You can also register on the site and go into your profile page at the bottom where you can upload an image.

  • wh10

    Cullen- we can even add that the ‘market influence’ is there because the Fed allows it.

  • Dumb Ox

    But the direction of this correlation is still an open question. The evidence may not support a bond market -> Fed influence, but it also doesn’t support a Fed -> bond market causation.


    You may not have a PhD but I think beowulf(otherwise known as the Federal Reserve Google)has at least 9.

  • jt26

    Just to emphasize, these are monthly correlations. If you think about longer correlations (i.e. 1 year, given the business cycle ~5-10 years), it can’t be true. Just think of the plot of 2s-10s for the last 30 years.

    I wonder also if this behaviour is just a market reaction … arbitrage, from FFR to 3mo, then arbitrage the 6 mo based on 3mo, etc. Between futures and physical. I.e the market is just one big algo that says, the best estimate of short term interest rate movements does not change the yield curve as the economy is slow to react.

  • wh10

    RE: the arbitrage- isn’t that what Cullen is saying (maybe I am misinterpreting you)? The market arbitrages against the FFR and expected future FFRs. The reason you see less correlation at the longer-end is because there is more uncertainty regarding what FFRs will be several years or more out (and there’s also liquidity issues that exist more acutely), and short term changes might not change that expectation.

  • jt26

    Yes, but the market is so “dumb” that on a monthly time scale …
    delta(“expected future FFRs.”)==0. I.e. they don’t have a clue. So the corollary to Fed power is market dumbness.
    But, if you look on a longer time-scale, they start to think for themselves, whether they are right or not is another thing. On a multiple-year time frame, the bond market systematically, misjudged the rates on the low side during the 60-70s, and then did the opposite in the 80s-00s.

  • http://marketthoughtsandanalysis.blogspot.com/ binve

    Thanks Peter, that’s a good tip.

    I made a Gravatar account and uploaded it, and nothing happened for hours. But then I checked and saw the default value was a ‘PG’ rating. I changed it to ‘G’ and it showed up here within 5 minutes.

  • beowulf

    I resent that! I admit to being a shyster lawyer true, but I’ve never taken an economics class in my life.

  • wh10


    I think this is some really interesting work. I think people are right to question the results and identify potential confounding variables, but I think you have provided strong rationale to defend the underlying takeaway at this level of mathematical rigor (as per the addendum).

    That said, I would HAVE to imagine there is much academic literature on this topic, including rigorous econometric analyses incorporating all the potential covariates people are concerned about. I’d bet Scott Fullwiler would be aware of the good stuff, if anyone would. Maybe reach out?

  • Peter D

    Bond market -> Fed reaction causation just doesn’t seem to make any sense. Why would the Fed react to the yield on 3 mos bill?
    The other direction makes perfect sense though. At short maturities the Tsys and the fed funds become very close substitutes, so, the rate differential disappears due to arbitrage. Then the longer Tsy yields are just the anticipated Fed Funds Rate moves + the term premia.

  • MS

    Is there a critical ratio for interest payments on sovereign debt (for an issuer like the US) that leads to a divergence point?

    If 20% of total revenue is interest, what does that mean?

    40%, 60%, etc?

    Understanding that we can print the money necessary to make the payments, what happens if interest payments are equivalent to tax revenue? All other functions of government would then only be possible if we create currency to cover the cost?

    Although theoretically not a problem, we can physically create the currency, what are the practical implications of such a debt level?

    This gets back to my tipping point question?

    Intuitively, there must be a point at which the interest on the debt becomes an impediment to an efficiently functioning economy.

    Once a government adopts a ZIRP, are they destined to keep it indefinitely?

  • wh10

    Cullen has always maintained that demand-pull inflation becomes a threat when the economy is near full capacity. An increasing amount of money has to be chasing a fixed supply of goods/services. This could happen with high interest/GDP or low interest/GDP. It’s all situation dependent. You can’t definitively pin it at X level of debt/gdp; it depends on a lot of different economic variables. Look at us now, look at Japan. It’s very possible to have low inflation and high debt levels.

  • Ian

    Are bonds overbought and is it yet time to short bonds (TBT) for a near term bounce?

  • alex p


    The Revolt has started. It’s the currency vigilantes this time.

    I was in the Army in the 1960’s in Germany. I got 4 marks to the dollar and 4 Swiss Francs. The Mark is gone but now I get .75 Swiss Francs.

    Gold is almost $1,700/oz on the way to $9,000 to reflect real money supply, real inflation, negative real interest rates etc.

    Who cares about bonds. You are looking at the wrong market.

  • http://www.pragcap.com Cullen Roche

    I’ve been bullish on bonds and gold for years now. It’s the only big long-term macro trade that I have disclosed on pragcap…..and it’s been very right.

  • John Zelnicker

    Cullen — I understand from your writings that you will remain bullish on bonds until you see some signal that the Fed is about to raise rates. What kind of signal would cause you to cease being bullish on gold? And do you consider silver to be a suitable substitute for gold as an investment?

  • Different Chris

    Thansk Pete & CR.

  • Ilya

    Rosy has been verbally stating what’s on this chart for at least a year (that Fed is the major driver of yilds. He has been reasonably right on the long dated curve if you had the guts to ride out waves of hate.

  • Peter D

    Cullen, this one is for you!

    Do I do this myself? Probably on occasion, when I don’t catch myself. But I try not to. I would say that commenters who begin with “I can’t believe that a Nobel prize winner doesn’t understand that …” might want to think a bit harder; mostly, though not always, I have actually thought whatever you’re saying through, and the obvious fallacy you think you’ve found, isn’t. But “Me big famous economist, you nobody” is not a valid argument.

  • http://www.pragcap.com Cullen Roche

    PK is a good man. Overly political, but no doubt a good man. I regret my comment about him the other day. That was really unfair of me to get my facts mixed up….