Sunday, February 3, 2019

January 2019 Yield Curve Update

I have discussed how there is a sort of mental accounting problem with the yield curve model.  The zero-slope is treated as a constant, when, in fact, meaningful inversion happens at low yields when the 10 year yield is as much as 1% higher than the fed funds rate, and at higher yields, the inversion has to become fairly steep to become meaningful.

During the past two months, the curve has become meaningfully inverted.  Here, in the Eurodollar futures market, the upward bias of the longer term yields is clear.  What is important is that forward rates in the 2-3 year time frame are inverted.  I suspect those 2021 Eurodollar contracts will close at rates much closer to zero.

Here is the plot of the Fed Funds Rate against the 10 year Treasury, shown with the adjusted inversion levels.  From this point, a normalized yield curve is highly unlikely to develop without lowering the Fed Funds Rate.  Expect the 10 year yield to be below 2% by the time that process is finished.


  1. Maybe the Fed corrected in last meeting. My guess is if the Federal Reserve had persisted in raising rates we would have seen the 2% interest rate on 10-year Treasuries of which you speak.

    The major central bankers of the world are facing a new situation, I think. The ECB BoJ and Fed face chronic aggregate demand shortages, and scant inflation. Quantitative easing appears to be a weak tea, and does not do much in terms of inflation rates--- which raises fascinating questions about monetizing national debts (an absolutely taboo subject in conventional monetary policy circles).

    In 2003, Ben Bernanke suggested money-financed fiscal programs for Japan.

    Certainly, helicopter drops appear to be a far simpler and more effective solution than trying to get results through the Rube Goldberg Federal Reserve policy apparatus.

    1. The problem is that the Fed is blamed for high asset prices. If that wasn't the case, they would hit their target and they wouldn't entertain the danger of contraction. Obviously NGDP level targeting would be helpful, but I don't see the point in doing the other things. They know how to increase nominal economic activity, and they can when they want to. It's just that they don't want to, and many others don't want them to.

  2. The problem is that the Fed is blamed for high asset prices.--KE.

    All the more reason to deploy money-financed fiscal programs.

    After all, the purpose of QE is to raise asset prices. Hard to dance around that, PR-wise. And lower interest rates raise bond values and property values. I understand what you are saying, that NGDPLT should be Job 1, and I agree.

    Side note: The IMF has said large and chronic current-account trade deficits lead to bloated asset values. If the "blowing asset values" crowd gets the upper-hand, you have the Fed putting a noose on the economy's neck due to inevitable results of chronic large trade deficits.

    The trade-deficit story is not explored. Is that what happened 2007-8? Bloating asset values and then the monetary noose?

    Along with housing, the results of the trade deficit are another mystery topic in conventional macroeconomic circles.

    As I have said, I think conventional macroeconomics has missed the boat on the three biggest macroeconomic issues of the day.

    1. The right monetary policy (the emphasis on inflation, not growth).

    2. The role of closed -access cities and housing in the economy, on living standards, and perceived inflation and asset values.

    3. Trade deficits. "Free trade" is so sacralized, that it is not polite to examine the trade deficit issue. Remember, there was even a larger run-up, and then plummet, of commercial property values in the Great Recession than in house prices.

    House prices got the ink and became the tribal battleground, but the story was bigger in commercial property.

    Maybe there is a book from you yet on commercial property.

    1. "After all, the purpose of QE is to raise asset prices"

      That's the nub of the problem. It isn't actually the purpose of QE, but as long as central banks insist on communicating primarily through the lens of short term liquidity effects on interest rates, they will feed the idea that it is the purpose.

    2. You are correct; the ultimate purpose of QE is economic growth. It may or may not work, or it may work but is rather weak tea.

      The cynic-Marxist-socialist gene in me (that I cannot extinguish) notes that the Fed's preferred solution to recession is first to raise asset values.

      Beyond QE, the whole Rube Goldberg monetary-policy system relies on commercial banks extending more loans (endogenous money-supply creation) to boost the economy. In other words, money is created for the right people. Of course, a large amount of this endogenously created money is merely sunk into existing property (Adair Turner has interesting views on this).

      This Fed contraption is better than money-financed fiscal programs (which worked to lift Japan out of the Great Depression)?

      Don't ask.

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