The Yield Curve Is Telling Us Something, but Not About the Fed
In the spring of 2013 Apple conducted a very successful, $17 billion debt offering. It was heavily oversubscribed at long and short maturities, and reflected the fact that investors trust the creditworthiness of one of the world’s most valuable corporations almost as much as they do the U.S. Treasury.
Apple’s popularity with investors rates discussion in consideration of all the recent hand wringing within the business media about the inverted yield curve. According to pundits on the left and right, the curve has inverted before every recession since 1955. Supposedly higher yields on two-year Treasuries relative to 10-year debt signal an overly restrictive Fed based on near-term borrowing becoming more expensive than long-term. So with the yield curve allegedly predictive of every recession going back decades, it's useful to stop right there and ask if so, as in if recessions are in fact man-made creations of the Fed, why market actors have never bothered to work around what has long been artificial.
It's seemingly a fair question, but to the yield-curve triggered, there's very little introspective thinking of this kind to be found. According to the obsessed, credit is tight all because of the Fed, the economy is slowing in response to said tightness, plus if we take the presumed logic of pundits to its inevitable conclusion, lower rates at the longer end of the Treasury curve signal reduced inflation expectations in the actual marketplace since, according to the Washington Post’s Jonelle Marte, “Inflation picks up when the economy gets hot.” It apparently never occurred to Marte to look beyond what seems true, only to find reality: economic growth that is always and everywhere a consequence of copious investment is all about falling, not rising prices,
After that, the follow-on assumptions that inform so much yield-curve babbling are rather easy to dismiss. More to the point, the limited knowledge of the pundit class becomes ever more apparent every time a supposedly predictive economic indicator starts predicting things. Little of what’s expressed as truth about an “inverted” yield curve stands up to the most basic of scrutiny.
For one, credit in the U.S. is a global concept. To pretend the slope of Treasury debt is somehow indicative of the global credit conditions that greatly influence U.S. credit availability is to miss what Ken Fisher regularly points out: yield curves around the world aren’t inverted.
For two, assuming supposed Fed “tightness” is the source of higher short-term rates as we're constantly being told, let’s dismiss somewhat the rate for it being, if the pundits are to be believed, an artificial creation. They claim the Fed is bringing about expensive near-term credit (a debatable presumption) by force of some kind, so it should be said that the shape of the Treasury curve is artificial if their narrative is to be accepted.
Once this is established, it's worth reminding readers that the Fed can neither create nor shrink credit; rather it can attempt to influence the amount of credit flowing through U.S. banks that are rapidly shrinking as a total percentage of what’s available to borrow. Supposedly tighter lending conditions from banks would only matter if they were anything like the only credit game in town. They’re not. Not even close. Not only is their market share in speedy decline, banks quite simply cannot be dynamic sources of credit allocation as evidenced by the low rate they pay for deposits. Think about the previous point for a minute, or maybe several. That banks pay so little for deposits, that the Fed funds rate (the central bank is a rate follower, not a rate setter despite what we’re told) is so low, is a telling clue about how much the Fed influences anything.
Third, we’re once again supposed to believe inversion signals a “tight” Fed. Ok, but what if Amazon, Apple and Microsoft were to float short-term debt of the two-year variety? Does anyone seriously think the borrowings of these three prominent companies would in any substantial way reflect presumed central-bank austerity? Readers know the answer. “Tight credit” is a relative concept. Apple likely doesn’t endure abnormally difficult credit conditions (assuming any difficulty) with an inverted yield curve, nor would any other blue-chip name. At the same time, the businesses that aren't blue chip are going to experience fairly difficult lending scenarios no matter the slope of the yield curve. Such is nature.
What if the Fed had continued raising raising the rate it sets after December of last year such that Fed funds were at 5% today. Does anyone really think that Apple would be paying something north of 5% to borrow? The answer is unlikely. Assuming a tight Fed existing as the source of more rigid credit conditions, do readers really believe global sources of lendable funds wouldn’t come in to fill the breach? In other words, assuming the Fed were to aggressively sell bonds to Silicon Valley banks with an eye on reducing loanable funds in the region, does anyone seriously believe that non-bank sources of credit wouldn’t gladly do what Fed-muzzled banks might not be doing?
Stating the obvious, the decentralized nature of capital flows strongly suggests that assuming a yield curve that’s inverted for artificial reasons (meaning a “tight” Fed), such a scenario would exist as a screaming opportunity for those not constrained by Fed machinations; as in most of global finance. In short, an artificially inverted yield curve in a growing economy wouldn’t shrink credit as much as it would re-orient how credit would reach worthy recipients.
Reversing the inverted scenario, let’s imagine a very steep yield curve; one made artificially steep by an “easy” Fed. If the central bank were capable of forcing this kind of market outcome despite a weakening economy, does anyone seriously think that Toys ‘R Us would still be operating as a result, and that several hundred more Sears and K-Mart stores would be open? Would Ford shares be higher to reflect a central bank that’s open for business? It’s hard to imagine any sentient being believing the Fed could reverse outcomes arrived at through market forces. More important, how would it advance economic progress if the Fed could prop up monuments to past economic glory like Sears? Back to reality, real markets will always reverse what makes no market sense, but that the Fed presumably wants.
Which brings us to a more basic question not asked enough. What if the yield curve is flattening not thanks to the Fed, but because market actors are becoming more cautious? For those who dismiss such a scenario outright, it might be wise to stop and deeply contemplate the ease with which you dismiss the question. The Fed once again can’t increase or shrink credit as much as it can influence where it’s accessed from. Lest readers forget, we borrow real resources when we seek credit, not “money.” Credit is production determined. Based on that, and if it’s true that inversion always precedes recession, then it must also be true that yield curve inversion reflects reality. As investment savant Howard Marks has long put it, "success carries the seeds of failure, and failure the seeds of success." Maybe the flattening yield curve reflects more cautious capital after years of economic growth?
All of the above is worth thinking about when we remember the myriad free-market types who think the Fed has the power to positively steepen the yield curve, and worse, think it should. Explicit there is that free market types are calling for the Fed to intervene in the normal doings of the credit markets. Why? Why would they want central bankers operating with highly limited information to bend markets possessing endless amounts? If the inversion is a market signal, why would it be a good thing if the Fed were to do as free market types desire, and alter it?
Implicit there is that the Fed could have somehow averted 2001 and 2008, and better yet, that we would be better off now had the Fed done just that. Such a view is hard to countenance. In the early 2000s it was plainly a good thing that eToys, theglobe.com and Webvan went bankrupt, and it was plainly a good thing that the rush into housing consumption was arrested by reality in 2008. What wasn’t good was intervention in the failure of banks and carmakers in ‘08 that, had they not been saved, would have wound up in more capable hands. It says here that the bailouts meant to rewrite reality not only caused a “financial crisis,” but they also slowed recovery by slowing the adjustments that untouched economic downturns necessitate. Applied to the Fed now, assuming the central bank can re-shape the yield curve in order to blunt any presumed recession, it’s hard to see why doing so would be wise.
So if it's true that inversion is a consequence of man-made errors made at the Fed, global markets will correct it. The growth obsessed needn't worry. Assuming inversion reflects reality, it’s naïve to assume that the Fed could somehow reverse the truth. More important, it shouldn’t.