Economics
For now, trust the yield curve
Jul 7th 2010, 20:58 by G.I. | WASHINGTON, DC
IF YOU'RE making a call on a double-dip recession, you must also make a call on the credibility of the yield curve. An inverted curve (with the ten-year Treasury yield falling below the three-month T-bill rate) has preceded each of America's last seven recessions. It has had two false positives, in 1966 and 1998, the Cleveland Fed notes. The lead time varies from a few months to two years. It is currently relatively steeply upward sloping.
Is this time different? By definition, when short-term rates are at zero as they are now, the yield curve can't invert, yet it would be ridiculous to say that means we can't have a recession. A correspondent points out that Japan's yield curve was positively sloped throughout the 1990s but Japan still had recessions.
With that caveat in mind, for now I'm going to trust the yield curve, for two reasons. First, people have said "this time is different" before to discount the yield curve's value as a leading indicator. In 2006-2007 some scholars argued an inversion that occurs when nominal short-term rates are low is less meaningful than when monetary policy is clearly restrictive. The lesson: think twice before explaining away the yield curve with special factors.
The second reason is that the yield curve owes its forecasting power to the powerful influence interest rates have on the business cycle. It's obvious that when the Fed jacks short-term rates up dramatically, that can, and does, slow the economy down. Less obvious, even when the tightening is relatively modest, as in 2007, is that when short-term rates rise above long-term rates it is a powerful retardant to credit creation. Our entire financial system relies on borrowing short and lending long and profiting from the spread. When that spread disappears, sooner or later, so does liquidity. In 2007, that happened in dramatic fashion, partly because we didn't realise how precarious liquidity was in the vast shadow banking system. Indeed, the more I study the events of the last few years, the more I'm convinced that illiquidity contributed more to the crisis than insolvency.
What all this tells me is that as long as the yield curve remains relatively steep, it is a powerful inducement to credit creation. Credit is currently contracting, but with time the positive lending spread will recapitalise banks and awaken interest in lending. Right now is an excellent time to start a bank: just check out the enthusiasm among private equity funds for buying failed banks from the FDIC.
I'm not ruling out a double dip. But in assessing its odds, you have to start by acknowledging that double-dips are rare: there aren't any in the post-war experience of the United States with the exception of 1980 and then 1981-82, and both those dips were deliberately induced by the Fed and preceded by an inverted yield curve.
Why might this time to be different? There's the risk of fiscal contraction. Arithmetically you could get a negative quarter or two of economic growth from the expiration of Barack Obama's stimulus and George Bush's tax cuts. Would that initiate a new, self-reinforcing downward cycle in activity, or just a transitory dip? The latter would be a double-dip recession in name, but not in spirit.
That brings us back to the Fed. It owes its influence over the business cycle to its powerful lever over liquidity. This lever has, in the post-war period, usually operated through the short-term interest rate, but that is not its only channel. Everyone blames the infamous 1937 depression-within-a-depression on premature fiscal austerity, but perhaps more important was the Fed's mistaken move to raise reserve requirements. Similarly, this year's European debt crisis was precipitated by the European Central Bank moving to end unlimited lending to banks against peripheral sovereign bond collateral (killing what had been a lucrative spread trade for European banks). It is thus conceivable that the Fed could, perhaps inadvertently, do some damage by a regulatory or policy change that saps liquidity again. I can't think what that might be, but it's a danger worth keeping in mind.
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I agree. We probably won't have a double dip, but maybe a slow down.
However, Washington is making job creation as difficult as possible according to a Fed member:
"Congress and the government have inhibited growth by creating uncertainty about business costs, Dallas Fed President Richard Fisher told CNBC Wednesday."
"We need clarity," said Fisher. "My background [in business] tells me that you can't eliminate uncertainty, but you have to reduce it as much as possible."
"Questions about healthcare expenses, for instance, have kept businesses from hiring new workers, said Fisher, because executives don't know how much it will cost them. Businesses also have concerns about other costs, such as whether a VAT [value-added tax] will be imposed."
from "Dallas Fed President Richard Fisher Explains How the Government is Making Things Worse" http://www.economicpolicyjournal.com/
"I can't think what that might be"? I can think of one good candidate - the financial reform bill that is currently grinding through Congress.
And this points out an unexpected way to be damagingly pro-cyclical. We find out, painfully, that leverage is too high. The shock creates a recession. As part of trying to make sure that it doesn't happen again, we raise reserve requirements. (Hey, this does kind of sound familiar...)
Basel III might be worrying me more than anything else at this point. That needs to take effect slowly.
"What all this tells me is that as long as the yield curve remains relatively steep, it is a powerful inducement to credit creation. Credit is currently contracting, but with time the positive lending spread will recapitalise banks and awaken interest in lending."
Ummm... I don't see credit being created. In fact, I don't foresee any credit being created anytime soon. Banks are not lending, even though (or maybe because) money is nearly free. The federal government was able to briefly spark sales in both autos and houses with generous giveaways, but the instant those giveaways dried up, the sales stopped. Consumers are also not borrowing; they are paying down debt, trying to stay afloat. Businesses are also not borrowing to expand. That is not going to change until jobs start getting created, people finally unload upside-down real estate they have been hanging on to, and their retirement accounts are fully replenished.
I do believe in the inverted yield curve as being a leading indicator of a recession, but it is important to understand that while the existence of a leading indicator is a good sign of a coming recession, the absence of a leading indicator is not proof that a recession is not coming. If you are driving along a twisting mountain road, the absence of a "dangerous curve" sign does not mean a cliff is not imminent.
I agree. And it was a liquidity crisis, as the rapid repayment of the lender of last resort has demonstrated. The new stupidity of mark-to-market created a misleading and purely technical insolvency by putting banks' capital at the mercy of a market panic.
The yield curve is one good item to look at.
It inverted on 7/19/06 until 5/26/07. One heck of a long time of inversion. I don't think there is a correlation between time inverted and time in recession, nor the amount of invertion to the depth of the slowdown.
A second inversion occurred 7/20/07 to 8/8/07.
"Credit is currently contracting, but with time the positive lending spread will recapitalise banks and awaken interest in lending."
But what about borrowing? Today I recieved a CaptialOne credit card mailing. 17.99% interest. Sorry, but I'm not going pay for the grasshoppers' mistakes, besides I have a credit card that has a much lower interest rate.
If we do have a 2nd dip it probably won't show in the yield curve. Probably another indicator the smart money uses will show it.
I'm on record as low inflation, low growth, high unemployment for the next 12-24 months. It might feel like a recession, it already does to the 10% who are unemployed.
I see Wells Fargo will boot 2,800 in the next 2 months, and the United Space Alliance will boot 1,400 by Sept 30. Toss in the multiplier effect and we go higher. ---
"I can't think what that might be, but it's a danger worth keeping in mind."
Congress not extending unemployment?
Capacity utilization still under 75%, which means no expansion?
Regards
I forgot to mention there was an inversion that ended in early March of 2006. Not sure if there was a carryover from Feb of 06, I'll have to update that data.
Regards
Hedgie, I'm wondering whether you type in "Regards" at the end of every post or if you've set up a macro or something to do it automatically. Regardless, it's a nice touch.
Don't know if it has already been linked, but James Hamilton has an excellent post up: http://www.econbrowser.com/archives/2010/07/bob_hall_on_fin.html#comments
Unless current policy changes (replacing existing bubble debt with current cheap debt instead of spending), another disaster is inevitable. We aren't getting the money where it is is needed; right now cheap money is exacerbating our current inefficiencies, whether there is inflation or deflation.
Doug:
"Regardless"? Was that intentional?
In this blog, our correspondents consider the fluctuations in the world economy and the policies intended to produce more booms than busts.
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