Thursday, August 8, 2019

July 2019 Yield Curve Update

The yield curve has taken a sudden turn for the worse.

The Fed's tradition of using interest rates to convey their monetary stance is such a constant source of confusion.  The conversation about yields so often seems to hinge on the idea that the central bank is in full control of interest rates and uses them to make it more or less profitable to borrow and invest.  It baffles me how ubiquitous this sort of idea is in both professional finance and economics.

Recent movements in yields are a great case in point.  It is common to hear this shift described in terms of expectations about Fed rate cuts.  But the whole yield curve shifted down.  This is not a sign that the Fed will be loosening monetary policy more aggressively.  This is a sign that they won't be loosening aggressively enough.  The neutral rate just changed, leaving the Fed behind as a victim of institutional inertia.  That is in contrast to recent times when yields did react to clear signals from the Fed that it was going to be more aggressive.  In those cases, short term rates fell and long term rates increased.

I only update my graph of the adjusted yield curve inversion monthly, so the red dot for July is at about the same spot as it was at the end of June.  Of course, the 10-year rate has dropped 25bp since then.  So, unless some sort of economic or political development greatly improves economic prospects in spite of a tight monetary posture, raising 10 year yields back up, then we are already at a point where, even with short-term rates at zero, the yield curve will be effectively inverted.  This will likely lead to complaints about how the Fed is using QE4 to keep long term interest rates low to boost investment and asset prices, including from many otherwise sensible people who are generously paid to manage other people's assets.


  1. Sometimes I pull out what hair I have left when reading even the best of financial media. One can read sentiments the years of easy money by major central banks have created this situation of negative interest rates.

    Or, as you said, long-term rates have come down as they expect the Fed to be easier.

    And then, a dangerous misdiagnosing. One can believe from reading financial media that that the global slowdown in economic expansion is due to Trump's tariffs.

    Sometimes pundits decry the public as uninformed. That is the least of it.

    1. Yes. It puts the question of regulation or federal management of the nominal economy in an odd light. People do really need to be protected from themselves. Yet, the experts can't even agree on the basic building blocks that would be required to provide that protection.

  2. What do you think about ECB's policy in comparison? Germany's yield curve hasn't inverted, but it's totally negative.

    My impression is that EZ's monetary policy is actually functioning reasonably, but they constantly fight against tight fiscal policies. And in US it's the reverse... if I'm correct, I wonder if looser monetary policy in EZ is because they only count actual rent in inflation and its a smaller part of inflation ECB doesn't get signals mixed (mistake shelter price increases for inflation that should be corrected with higher rates when it's really supply problem - and ECB almost just ignores shelter).

    It would be sad if such technical choices led to millions of Americans be without homes. I doubt even the miserliest German government could achieve such unnecessary deprivation

    1. I'm not informed enough on the ECB to have a strong opinion. My initial reaction to your comment is that lower Eurozone NGDP growth and inflation suggest that ECB policy is tighter than US policy, not looser. On the other hand, if those measures are shaded down in Europe relative to the US because of your point about the way they measure rent inflation, then maybe ECB policy isn't as tight as it seems compared to US policy. That's an interesting point. Thanks for the input.

  3. Thank you! Here I found this:

    "US CPI and the euro area HICP
    differ in terms of their coverage of housing costs. The former includes owner-occupiers’ costs
    for shelter in the form of imputed rental payments, while the latter does not cover the shelter
    costs of owner-occupied housing.

    Owners’ equivalent rents constitute around 24% of the cost of
    living covered by the US CPI. By contrast, actual rents account for around 6% of the basket of
    both the US CPI and the euro area HICP."

    source: › ...PDF
    Euro area house prices and the rent component of the HICP

    This from 2016: Assessing the impact of housing costs on HICP inflation

    "After falling to a little under 1.5% in 2010, rental
    inflation declined further to around 1.0% in 2015, well below the long-term average of
    1.7% (see Chart A). Developments in rental prices over the past few years have therefore not supported services inflation, but been an integral part of its decline."

    Note towards the end about heterogeneity within Eurozone. Real estate is local (capital markets global!)

    And recent developments:

    It therefore might be true that EZ monetary policy was too tight vs Fed (hicp understated shelter _deflation_), but is now more accommodative. Implies ECB monetary policy will become relatively more accommodative if shelter (rents, house price increase) remains understated. ECB then is going to be slower hiking rates. Fed faster both ways. Interesting dynamics since they are 2 sumo wrestlers in hot tub, the other stands up, the other goes down.

    (Shelter inflation in EZ might also be understated because of widespread rent controls. In those cases the inflation might appear in house prices in countries with rigid supply, cheap credit, low unemployment. And that's exactly what happened/happens in Netherlands, Germany, Sweden...).

    Real non financ M1 in EZ has risen solidly for some time now, credit flowing to households, vs in usa not so much, implying looser policy in EZ.

    Hypothesis: Fed misread signals badly last year, possibly because of _technical_ choices made in calculating inflation index originally. The difficulties constructing single price index that takes into account idiosyncracies were discussed in links above. It's always a compromise. But maybe ECB overall chose better than the Fed?

    Sorry for writing this long.

    1. Thanks. I'll check those links out when I have time.


    Cities with higher costs growing faster...