Monday, November 11, 2019

Mid month Yield Curve Update

Enough has happened in credit markets that I figured it was time to update charts.  The long end of the curve has moved up a bit, which has led to some expressions of relief.  I'm not sure we're totally out of the weeds.

The entire curve has moved up from its lows by about 1/2%.  That's mildly bullish.  It suggests that the market doesn't think the Fed has to react quite as strongly to maintain stability.  But, what would really be bullish is if short term rates were at more like 1% and the long end of the curve would be at 3%+ (circa 2003).  That was a yield curve of a marginally neutral central bank creating stability.  But, because of the housing bubble, very few people believe that about 2003, so it still seems to me that the pressure will be to take a hawkish posture, and eventually, the yield curve will move back down.

The second graph here compares the Fed Funds rate and the 10 year yield from 2004 to the present.  The diagonal lines are my estimation of a functionally inverted yield curve.  While the recent uptick is reassuring, for it to really signal that we are out of the woods, the 10 year yield needs to move up to 3% or more without being followed up by the Fed Funds rate.  Until then, I consider these recent movements to be noise while we are still basically inverted (circa 2006-2007).

One thing to check is housing markets.  The more recovery we see there, the more likely we are to be safe.  That is growth in price, sales, and borrowing.  Rising prices and rising borrowing would signal that the channel for capital to react to low yields by flowing into real estate is operating (though it is hobbled at best in today's regulatory environment).  Rising new sales would signal that financial capital is capable of funding real investment.  In other words, strong home prices would show that prices can react to fundamentals, strong housing starts would show that real investment can react to changing prices, and rising borrowing is the connective tissue for these market responses.  I suspect that an inverted yield curve reflects a breakdown in those mechanisms, which is why it is a good predictor of recessions.

This is not to say that home prices have to move in an ever-rising cycle in order to maintain economic growth.  The problem with housing is constrained supply, through local regulations and now through disastrously tight federal mortgage regulation.  These factors drive up rents, and I suspect also put downward pressure on interest rates, since residential investment should, but can't, be a moderating influence on long term real yields, keeping them from being persistently too high or low.  Building lots of homes would bring down home prices. 

The third graph shows the Fed Funds rate and 10 year yield from 1994 to 2002.  In 1996, the curve flirted with inversion, and the Fed responded by lowering the Fed Funds rate, which was followed by recovery in long term rates.  This happened again in 1999, and at first, the Fed stayed put as long term rates rose, but then it followed them up too aggressively.  By 2000, the recessionary signal was starting to develop.  First, a rising Fed Funds rate pushed the curve to inversion, which became stronger as long term rates declined.  Then, the tepid response meant that the Fed Funds rate declined over the next couple of years, remaining contractionary enough to keep long term rates from rising.  The same thing happened in 2007-2008.

It seems as though, in the 1970s, the Fed generally erred on the dovish side, inflation was getting too high, and the long end of the curve would rise while the Fed deeply inverted the curve.  Since 1980, the Fed has generally erred on the hawkish side, inflation has remained moderate, and recessions have been avoided when the long end was allowed to rise, but have followed when the long end has remained level during inversions.

Of course, this whole tightrope could be avoided if the Fed abandoned interest rates as a communication device and policy tool and instead targeted forward domestic income growth.

Going forward, if the 10 year doesn't rise much from here, then I would expect a typical descent into a contraction, with the Fed following the yield curve back down to zero.  If it does rise from here, up to something above 3%, then either 1996 or 1999 will be a good guide, and either we will avoid contraction altogether or yields will follow the clockwise path similar to the 1999 to 2002 path, and a contraction will eventually happen, but we will get another year or two of expansion first.

I continue to fear that a misunderstanding of the causes of the financial crisis will create pressure both on and off the FOMC to be too hawkish, but I must admit that the Fed was more willing to reverse their recent rate hikes than I had expected them to be, to our benefit. There is some hope that the Fed might continue to be responsive.


  1. Great blogging. I sense that in the last 10 in 20 years capital markets have become increasingly globalized. Mark Carney of the Bank of England recently said he has no control over long-term interest rates.

    Even Claudio Borio of BIS says fiscal stimulus is needed, that central banks are exhausted.

    Perhaps interest rates reveal less about any particular regional or national economy than before. But the nice thing about macroeconomics, is that no one is ever wrong.

  2. > Even Claudio Borio of BIS says fiscal stimulus is needed, that central banks are exhausted.

    As long as interest rates are above zero, there's zero reason for fiscal stimulus.

    (And even below zero there's no reason. But that's more controversial.)