The Fallacy Of the Steep Yield Curve
The sudden and uniform deceleration in economic activity has caught nearly every economist and Fed employee completely by surprise. Though mainstream economists have been wrong so much in the past few years, we are told to idly accept the proposition that the second half of the year will see real growth that will actually include new jobs. Another "transitory" "soft patch" is in the offing, posing no material concerns to the professional economist class and their models. The basis for both the surprising nature of the economic ebb and the unbridled optimism for the rest of 2011 share a single root.
It is taken as an article of faith among mainstream economists and monetary policy governors that a steep yield curve is an essential component of stimulus. Not only that, the steepness of the yield curve is unquestionably believed to be a primary factor driving economic activity.
The theory seems sound on its face - low cost of borrowing (the shorter end of the interest rate curve) combined with a much higher return on lending (the longer end of the interest rate curve) induces financial intermediaries to begin or accelerate intermediation. The steeper the curve, that is, the bigger the difference between the cost of borrowing and proceeds of lending, the greater the profit potential for banks. Increased credit growth should naturally follow, meaning more economic activity.
This, together with the maxim that low interest rates stimulate borrowing, forms one of the main pillars of modern monetary thought. Indeed, the Federal Reserve has craftily embraced this widely held belief by keeping interest rates as low as possible, pushing the entire treasury curve downward, while at the same time fostering and maintaining a steep slope. This sharp gradient has remained relatively intact since May 2009, the onset of the Fed's first iteration of quantitative easing (QE 1.0). Since most interest rates in the United States are based on U.S. treasury yields, the impact of manipulating this specific curve is systemic.
In the past, the yield curve has presented good information about the health and the direction of the economy. The treasury market is big and liquid enough to allow for the aggregation and transmission of true risk expectations. So the basis for relying on it is well grounded in history. But there are two irreconcilable incongruities to putting faith in it now.
First, if we identify its usefulness as a function of market identification and further quantification of risk expectations, then the steepness of the yield curve, to preserve any of this information, must be a product of the marketplace. To have any useful basis, it has to be unadulterated and free from intervention.
Can we take the yield curve at face value if we know that the mass of transactions that make up its price discovery mechanisms are full of purchases by an entity that gives no distinction or thought to risk/return when executing bond trades? If the full value of the information content of the yield curve is supposed to be a product of millions of disagreements on the risk/return expectations, then that content is diluted by transactions that have no grounding in that primary calculus.
Dilution is probably understating the case by an order of magnitude since the Federal Reserve has been actively moving the yield curve at both ends. In other words, the Fed is the yield curve, through QE 1.0 and 2.0, and its actions have little to do with risk expectations. So how can anyone rightly say what the yield curve is telling us about those expectations?
The first rule of market interventions is to throw price discovery out the window. Without true price discovery there can be no interpretive value to executed transactions since they are based on largely irrelevant criterion.
Part of the mystique of the yield curve's predictive capacity is certainly centered on its rather rare inversions. When short-term rates exceed long-term rates, when the yield curve goes from a steep to a negative slope, the onset of a recession or economic dislocation is typically twelve to eighteen months in the future. The risk expectations embedded within that market-based curve show a rising expectation of risks concentrating in the near-term, so much so that investors will only invest in short-term credit at rates greater than those of longer-term credit.
Since December 2008, however, the short end of the yield curve has been pinned at near-zero due entirely to the Federal Reserve's zero interest rate policy (ZIRP). That policy is intended to, as stated above, encourage borrowing activity. ZIRP is completely unrelated to the risk expectations of market participants.
At the other end of the curve, the Fed has less influence, but it is not zero. Through QE 2.0, the Fed has purchased billions of dollars of longer-dated treasuries, often still on-the-run treasury notes not far out from auction. This undoubtedly has an effect on rates, though it is not at all clear what that effect even is. Interest rates in general fell during the pre-QE 2.0 period and then rose during its execution. Both movements were contrary to established expectations.
While studying this very unique phenomenon, I came to the uneasy conclusion that interest rates at the longer end were signaling absolutely nothing about the economy or risk expectations. In my opinion, the data suggests that interest rate movements of mid-2010 to early-2011 were primarily a function of primary dealers loading up on government bonds with the very reasonable expectation of flipping them to the Fed at a later date (and at risk-free, economically useless profit). If that was the case, how can anyone know what interest rates were telling us about actual, market-based perceptions of credit, and therefore economic, risks?
There is also the curious case of interest rate movements related to repo market irregularities (see more here). It is entirely possible, in my opinion more than probable, that the significant decline in mid-to-longer term interest rates since April 5, 2011, is entirely a function of a forced short-covering due to regulatory changes. Again, more interference produces more confusion at the expense of true price discovery.
Even if my assumptions about the longer-dated treasuries are incorrect, the intrusion of monetary policy at the short-end should be enough to invalidate the predictive capacity of the yield curve's shape. The Fed's intervention, rather than signaling forward true market perceptions about future risk, is intended to influence them. At the best case, the yield curve's steepness is a psychological ploy to allay credit-based fears. At this point, the yield curve can only tell us what the Fed wants us to see, not what the market actually believes.
The second problem of over-reliance on the yield curve is that it has already completely failed to do what it was supposed to. The profit enticement aspect has not delivered any growth in credit. The only sectors employing new debt have been large corporate borrowers and the federal government. The latter, for now anyway, is not an intermediary, and the former is adding debt exclusively through bond offerings.
If the yield curve's steep shape is supposed to, as economists unequivocally believe, stimulate intermediation it has yet to do so despite the passage of more than two years. Contrary to all mainstream expectations, intermediation has continued to outright contract. Worse still, the contraction continues in the sectors that the Fed and economists are counting on the most to ignite a self-sustaining recovery: small businesses and consumers/households.
According to the Federal Reserve itself, consumer credit has declined by $90 billion since the outset of QE 1.0 in May 2009. And even that number is misleading since it includes non-revolving credit issued by the federal government (mostly for student loans that are not influenced by the yield curve or even profitability). Stripping out the government, consumer credit fell by a total of $320 billion. Since June 2009, total home mortgages have dropped by nearly $465 billion (through March 2011) and credit for small business has fallen by almost $450 billion. All the while the yield curve has spent most of the time at record steepness.
With these astounding numbers, it is hard to see why anyone could place continued faith in intermediation going forward. What is really surprising/intriguing is that it takes only a small effort to explain why credit is devolving despite the monetary pillars.
First of all, lending standards across the industry have increased markedly since the Wild West days of subprime housing mania. This means a significantly shrunken pool of borrowers. Lenders now seem to care about loss rates on credit and credit products, and are taking them into full account when initiating arrangements.
This leads into a second problem for intermediation, in that ZIRP is having the opposite effect of its intended "stimulation". With the entire interest rate regime shifted lower to encourage borrowing, lenders are finding that risk is, and has been, mispriced given the ongoing realities. It is hard to argue with the math.
A thirty-year conventional mortgage is yielding about 4.5%, give or take a few basis points. Is that enough of a potential return, given that banks must lock up funds for about seven and a half years (the average duration of a mortgage) in an illiquid instrument (now that securitizations are dead) with delinquency rates still running near 9%? There is no ambiguity as to why the mortgage market is now the sole fiefdom of the federal government, where losses are always transferred to someone else. Private lenders cannot make money on so little interest.
The same holds true for consumer credit and small businesses. Loans simply do not yield enough given the too-slowly improving delinquency and default rate environment.
But as much as these are deterrents to lending activity themselves, the principal issue holding back intermediation is balance sheet capacity. Banks and financial firms just do not have enough capital to increase economically "beneficial" credit. It is really that simple.
Given the rules that govern capital adequacy and the lack of a securitized or off-balance sheet alternative, financial firms have little choice but to lend only to the most liquid and "safe" obligors - sovereign and large corporate debt. Sovereign debt can be added to a bank's balance sheet at a zero risk weighting, meaning that it does not get included in any capital adequacy measurement. So a bank can add U.S. treasuries or UK gilts without increasing its capital requirements.
In addition to the capital calculations, sovereigns and corporates are among the few repo-eligible options left. Repos (repurchase agreements) are very short-term collateralized loans that offer a financial firm the cheapest option for continuous funding (these loans are continuously rolled over). In the heyday of the housing bubble, banks were using AAA and AA-rated mortgage bonds as collateral in the repo market. Now that mortgage bonds are shunned completely, there are only so many "safe" collateral options. So to preserve repo funding banks can only purchase "safe" credit. That included, until recently, Greek, Irish and Portuguese debt, explaining why so many banks are so exposed to PIIGS.
The choice of lending options is really quite limited and painfully clear: a 4.5% conventional mortgage that counts 50% toward capital adequacy, has a near 9% delinquency rate, and cannot be securitized into a repo-eligible security, or a U.S. treasury that yields a similar amount, does not count at all for capital adequacy purposes, has no delinquency (yet), and is readily accepted as repo collateral.
In my company's April 2011 Special Report (which includes a much more detailed discussion of the balance sheet capacity issue), I wrote that:
"All of these factors form what we have called the Zero Upper Bound (ZUB). At the ZUB monetary policy ceases to work as intended. It also creates another problem. It confuses and confounds standard monetary theory and models...The mechanics of circulation are trying to show that returning to 2007 is not an option, no matter the quantity and cost of money. The attempt to manage economies is distorting markets and signals, making the transition to the real economic potential much more difficult than it already is."
Economic models and theory that currently rely on the yield curve for predictions (which is pretty much all of them) would certainly be surprised that the economy has slowed again. And they would also be convinced that the future is bright. Unfortunately for them and the economy, the yield curve's shape and composition would likely reveal something entirely different if it was ever allowed to.
Though it is beyond the scope of the discussion here, this all fits into a larger framework of true economic potential. One of the key takeaways from the myth of the yield curve, in addition to the fractured context of monetary policy, is that the banking system, no matter how much "stimulus" is applied, simply does not have the capacity or potential to recreate the economy as it was just a few years ago - which is a good thing.
In that very important sense, it is representative of what I believe is the real economic problem. Monetary policy that is crafted to re-create 2007 cannot possibly succeed. Instead of incessantly trying to force it backwards, economists and monetary policymakers might do well to ditch the yield curve and money creation measures in favor of recognizing true economic potential freed from the constraints of credit creation.
An economy is not supposed to be built on debt, it is supposed to be a function of self-sustaining profitability governed by market discipline. The importance of intermediation has grown way out of proportion to what a true, self-sustaining economy actually is. The absence of that true economy in the age of overwrought monetary interventions should be neither a surprise nor expected in the near future.