Wednesday, September 29, 2010
Ever since the Aug 10th FOMC statement—in which the Fed announced it would be buying longer-term Treasury securities with the proceeds of its maturing or prepaid Agency and MBS holdings—there has been a very interesting and tight correlation between the slope of the Treasury yield curve from 10 to 30 years and the market's own inflation expectations. This is shown in the above chart, with the red line representing the 5-yr, 5-yr forward inflation expectations embedded in TIPS securities, and the blue line representing the slope of the Treasury yield curve from 10 to 30 years.
What stands out is that the slope of the longer end of the yield curve is now a good proxy for the market's inflation expectations. That is at it should be, of course, since the higher inflation expectations, the greater the premium that investors should demand to own 30-yr bonds instead of 10-yr bonds. But it hasn't been that way for some time. And as the next chart shows, the slope of the 2-10 portion of the yield curve has been trending down all year even as inflation expectations have perked up. Plus, the flattening of the 2-10 portion of the curve has occurred under very unusual circumstances. (Typically, the curve flattens when the Fed pushes up short-term rates, and it steepens when the Fed lowers rates. For some time now, the Fed has kept short-term rates steady at very low levels, while longer-term rates have been falling.)
So the behavior of the yield curve is telling us something important, namely that the Fed's purchases of (and intention to continue purchasing) longer-term Treasury notes is having an impact. The Fed is artificially depressing yields out to 10 years, and that's not surprising because that's what they are aiming for. The Fed believes that lower long-term yields will be stimulative for the economy.
Whether the Fed's purchases of bonds will prove to be a stimulus for the economy remains to be seen, of course. Since early August, lower 5-yr and 10-yr Treasury yields have not resulted in any significant decline in mortgage rates, for example, because the spread between Treasuries and mortgage rates has simply widened. This is not unusual at all, it is simply the market saying that it doesn't believe lower Treasury yields are permanent, and/or it doesn't think that buying mortgages at lower yields is likely to prove profitable. And even if the Fed were able to drive mortgage rates to artificially low levels, I think it's questionable at best whether this would prove to be a stimulus for the economy.
Artificially low borrowing costs are part of the reason we're in the mess we're in. Cheap credit, among other things, helped fuel the housing boom, which eventually went bust. Flooding the system with money could help bail out underwater homeowners by pushing up home prices, but only at the cost of another round of reflation (perhaps housing prices, or in some other area of the economy, who knows?). Plus, it's hard to convince people to borrow these days, when so many are still smarting from having borrowed too much some years ago.
But I suppose that if the Fed tried hard enough for long enough, it would soon become apparent to intelligent people that taking out a whopping big mortgage was a good way to become rich. Borrow now at a super-low fixed rate for 30 years, buy a bigger home or some other tangible asset, then sit back and wait for the price level to rise and reduce the cost of repaying your loan. If enough people decide to borrow more, that translates into a reduction in the demand for money, and that has the effect of increasing the amount of money in the system relative to the prices of goods and services. It shouldn't be hard to see how that would in turn result in a higher price level for just about everything. It won't, however, result in any material change in the economy's ability to grow, since growth only occurs when the productivity of labor rises—when we collectively produce more for a given amount of effort.
I think the bond market is already thinking along these lines, and that is why the long end of the yield curve is steepening. The Fed may be able to depress 10-yr yields by promising to keep the funds rate at zero for an extended period of time, but there is no way the Fed can convince investors to buy 30-yr bonds a ridiculously low yields. Savvy investors are figuring this out: quantitative easing is going to push up inflation, so the thing to do is to shun long-term bonds (or borrow at long-term rates), and buy tangible assets or other currencies. Did I mention that gold and other currencies are already rising? And that's why the steepening of the long end of the curve is indeed a good sign that quantitative easing is going to lift inflation.
Along the way to higher inflation—which could take years to show up—this Fed exercise in quantitative easing may have at least one salutary effect, and that will be to vanquish the widespread fears of deflation. Convincing people that holding onto cash yielding zero is a bad idea is one way of boosting the velocity of money, and that is in turn a way of boosting the economy, if only because velocity has been very depressed. People have been hoarding money since the financial crisis erupted, and the hoarding continues to this day. That has depressed growth in the economy, which is another way of saying that fear of the future and risk aversion are not compatible with healthy growth.
I'm not condoning a QE2, however. I am hopeful, in fact, that it will not prove necessary, and I think that will become obvious as more signs of economic growth show up in coming months.
Posted by Scott Grannis at 5:01 PM