Monday, March 2, 2020

February 2020 Yield Curve Update

Well, this month appears to have presented the triggering event that will tip the Fed's hawkish bias over the tipping point.  It seems likely now that the Fed will chase the natural rate down to zero from here and there will be some sort of traditional contraction or recession related to the cycle.  In other words, in the second chart, we should have hoped for the dots to move up, but instead, they will likely move sharply to the left.  That chart uses monthly averages, so the 10-year yield is already well below the February point (in red).  The Fed is expected to announce an emergency rate cut.  Obviously, they should.  But, unless sub-1% short rates somehow leads to the 10 year moving up to 2% or 3%, there will likely be some period of economic contraction before rates increase again.

That means there probably still are some gains to be wrung out of a long bond position.  Regarding the other asset classes, however, housing looks increasingly bullish, and is relatively defensive in the current context, so I don't think there is much to fear in real estate.  And, equities certainly could decline, maybe even enough to become a legitimate bear market, but it is possible that they won't decline precipitously.  I think the jury is still out on that, though whatever the indexes do, this will likely be a trader's market for a while.  At some point, beaten down stocks will present long opportunities.

That relates to one bright spot in this month's update.  The yield curve has been inverted at the short end since early 2019.  The date of the expected rate low point had been September 2021 for a while.  As the last chart shows, we seem to have been moving toward that date, suggesting that there has been enough momentum in the economy to get back to a normal yield curve eventually.  But, the curve has been flattening lately, and it looked like it might tip back to December 2021 or even March 2022, which would suggest that we aren't really moving closer to a normal yield curve and that, as with the periods between QEs, more Fed loosening would be necessary to kick rates up over time.

But, with the corona virus dust up, even though yields have dropped down significantly, much of that has been at the short end.  In other words, markets expect the Fed to react.  So, even though most indicators in the past week have been negative, the yield curve has actually tilted up a little bit, and now the rate low point has moved to June 2021.  In other words, the negative thesis has probably been confirmed (We will proceed through a standard yield curve related contraction.) but as we proceed through the contraction, the market expects the Fed to be nimble enough to prevent it from being too deep or long-lasting.  I hope that's the case.

Disclosure: I have long positions in HOV, VNQ, and UBT.


  1. I had hoped that the Fed had learned. Their last rate cuts were a bit late, but early enough to avoid a recession.

    I'm actually more hopeful for the Chinese economy: their central bank seems to have less restraint when it comes to keeping nominal spending in the economy flowing.

    The complication I can see for them is that they seem to be very concerned about the exchange rate: the RMB should have dropped naturally throughout the virus situation so far, but the exchange rate seems fairly stable. Or rather stabilised.

  2. Do you really think this will blow quickly? Do you think that monetary policy is going to be effective?

    I've got two words: Diamond Princess. It's the most accurate case with clearly known contractions. Up to half are asymptomatic. Still 1% mortality (passenger demographics are tilted old, but offset somewhat by abundant health care resources), with dozens in intensive care, with more deaths expected. The implications are staggering if the experts' assessment of up to 50-70% infection rate. This is demographics influencing numbers. If old people start dying in large numbers, younger non-risk group people stop going to movie theaters, shops etc to try to avoid contracting the disease and spreading it to loved ones. I already told my family and friends to go see a movie, visit theater, a concert, football match etc because the next opportunity could be far into the next year. Schools will be shut, kindergartens emptied, olympics postponed.

    A single contraction in top level football (soccer) and that league is going to be frozen until the pandemic has run its course. Premier League is huge business. All it takes is one case and billions will be lost. Now repeat that in every single sport on the planet.

    1. It would be interesting to know the demographics of the Diamond Princess.... how many people are over age 70 for example? How many people have compromised health and immune systems? Suppose cruise lines attract sedentary travelers----people who are sedentary because they are old or ill? (I had one friend who patronized cruise lines as it was the easiest way to travel, and did not involve a lot of embarking and disembarking airplanes, finding hotels and carrying luggage around.)

      South Korea is posting death rates on coronavirus at about one half of 1%. But even this figure supposes that everyone who has contracted coronavirus has been tested in South Korea, which I find unlikely.

      My guess is that actual death rates from a coronavirus infection are probably near one tenth of 1%. As you stated, a large fraction of people are asymptomatic and therefore would never visit a doctor or be tested.

  3. Heck, how many sport clubs do you think will collapse, and what the stadiums are going to be valued at if people will _voluntarily_ avoid them? Commercial real estate? That is a lot of money on meager returns and high prices. I really worry about commercial real estate if others are like me. It's not like residential, where people must live. If you don't want to go to the mall, you don't have to.

    1. I don't have an opinion on corona virus. If it becomes as bad as you say here, then certainly I would expect more of a temporary downturn in the economy and in equity markets, regardless of what the Fed does. That's all the more reason for the Fed to avoid adding a monetary demand shock to the economy.

    2. I understand and thankfully Fed is showing initiative. The market unfortunately responded poorly. I recall the same behaviour 2008 before Lehmann. It is worrying.

      Here's Olivier Blanchard's take on ncov and effectiveness of fiscal and monetary policy.

  4. Great post. The Fed can't stop fighting inflation. It is in the central banker's DNA

    Stanley Fischer recently advocated helicopter drops. I think this is the correct approach when we have globalised capital markets and interest rates are near zero bound anyway.