Tuesday, February 9, 2016

Another Brief Note on the Yield Curve

Saw this on twitter today:
Here is the CME Group interactive Fed Watch tool.  These models show that yesterday, the odds of a rate hike at all in 2016 were about 35%.  That has fallen to about 25% today.  My model, which is based on the curvature of the yield curve showed a mean expected rate hike date in August, yesterday.  But today, that has moved all the way back to May 2017, with a slope after that which is still about 8 or 9 basis points per quarter.

I use Excel Solver to do the estimate, and, interestingly, Solver seems to have more than one optimal answer on the yield curve data from yesterday and today.  One answer is the August and May inflection points.  The other answer is basically that the next rate hike is highly uncertain, and far in the future.  Since expectations of remaining at zero do not affect the inflection point, because there is no inflection point in that case, I think my model is giving a different answer than the models that are based on rate levels.  I think the correct way to read all of this is that about 1/3 of the market thinks rates will rise, with a mean date of next May, and it will rise by about 25 basis points per quarter.  The other 2/3 of the market thinks rates will not rise at all.

The biggest red flag here is that, as far as I can tell, there is apparently zero expectation of a possible retrenchment.  The clear response right now would be to take a do-over and move rates back to near zero.  And there is no expectation of that happening at all, that I can tell.

The populists and Austrians think this is just proof that we have a bubble economy that can't grow without monetary stimulus.  They seem to like it when this happens, as if the S&P 500 at 2100 was fake and it is only real at 1850, or maybe 1600, or maybe less.  We've got a case of national Munchausen Syndrome.

Don't even worry about suggesting some optimal monetary policy.  Just give me a policy that isn't vulnerable to explicit communal self-immolation.


  1. If self-immolation leads to no inflation, there are many on the FOMC that will call that a success.

    Indeed, there is large body of monetary-policy types who contend that the Fed's only job is no inflation, and that all growth must come "naturally" or through the reduction of structural impediments.

    But then, no one ever mentions property zoning, the $1 trillion a year "national security" budget (DoD, DHS, VA, black budget, debt service), entrenched occupational licensing, the ethanol-fuel program, sugar import barriers, the USDA-rural subsidy empire, the home mortgage interest tax education, or IOER at 0.50%.

    But we do hear about bad taxi drivers (Uber) and the minimum wage.

  2. Doesn't the overall level of debt in the economy now also effect what level of inflation (or NGDP) the Fed should target? For example, we (collectively) have taken out more debt in the past expecting nominal incomes to rise by 5%-7%. Now our expectations shift for nominal incomes to rise by 3%, so we're all forced to reduce our debt level simultaneously to adjust to our new expectations. Once that shift happens, a 0% inflation/3% real income rise could work, though that shift in itself reduces nominal incomes further.

    In any case, it's more the moving target that causes us all problems, especially when the target (for no reason given by the Fed) for nominal income growth is now much lower than in the past.

    1. Hmm. Good points. But, I don't know. To the extent that lower real or nominal growth is reflected in interest rates, I'm not sure if it would effect debt levels. Actually, I would argue that normally lower growth expectations would raise debt levels because it would lead to lower real rates, increasing the value of homes. In fact, I think that is part of the story in the late 1990s and early 2000s. I would say that debt is lower now because of credit supply constraints and home equity disequilibrium, not because of an innate lack of demand for it.

      But, I agree the moving target poses a problem. In fact, I think that the apparent pattern of having a fiat currency with long-term changes in policy regimes makes nominal bonds a terrible hedge for stocks, because stocks are, more or less, a real asset, with most of their exposure related to the business cycle. Nominal bonds do hedge the business cycle risk, but over the long term they add a whole bunch of risk because of these long-term inflation regimes. When equities were out of favor during the high inflation of the 1970s, those long term treasuries bought as a hedge in the 1950s and 1960s weren't doing a whole lot of good.