Thursday, October 20, 2011

Yield curve continues to suggest growth


The slope of the yield curve has been a good indicator of the headwinds facing the economy: a flat or inverted curve is a sign of tight monetary policy and a relative shortage of liquidity, while a positively sloped curve is a sign of easy monetary policy and an abundance of liquidity. This chart looks at the slope between 2- and 5-yr Treasuries, and there is no indication here that the economy is facing any serious monetary headwinds. The Fed may be up against the zero boundary for short-term rates, but the market expects that the Fed will be raising rates over the next several years.


This chart looks at the spread between 1- and 10-yr Treasuries, and the message is the same: the yield curve is plenty steep and non-threatening. It also shows the real Federal funds rate (using the PCE Core deflator), which is another way of measuring how easy or how tight monetary policy happens to be. By this measure, monetary policy has rarely been this easy. Every recession in the past 50 years has been preceded by a marked flattening of the curve, and all business cycle recoveries have been accompanied by a relatively steep yield curve and relatively easy monetary policy.  Conclusion: key indicators of monetary policy show absolutely no threat to continued economic growth.

7 comments:

Bill said...

For what it's worth, the New York Fed treasury model shows the chances of a recession through September 2012 at a bit more than 3%.

Pragmatic Investor said...

Let me ask you: if a recession is always preceded by inverted yield curve, why could not the Fed always keep the Fed fund rate at zero? That way the yield curve will be upward sloping and we will never have recessions. Inflation may be high at times but at least the economy will always grow. I wish monetary policy was that easy.

Unknown said...

ECRI said a new recession is coming. Their batting average is excellent.

Benjamin said...

Not sure why the Fed is satisfied with such glacial growth, given the huge untapped potential in our national infrastructure, people, and private sector.

Output could rise by 15-20 percent without us hardly breaking a sweat.

PerformanceSpeaksForItself said...

Scott, thanks for the blog, I'm a regular reader, its great. One question for you: how useful is the yield curve today as a measure of economic activity, or future indicator of, with so much Fed intervention (QE, Twist, expectations of more)?

Scott Grannis said...

The Fed is trying to manipulate the bond market, to be sure, so it's possible the yield curve could be sending false signals. But I am of the belief that while the Fed can absolutely control short-term interest rates, it has very little control over the yield curve from 10 years out. That's because longer term interest rates are determined by inflation fundamentals and market expectations of what the Fed will do in the future. We know the Fed can't stay at zero forever, so 10- and even 5-yr rates are implicitly forecasting a future Fed tightening. This same type of expectation (that the economy will pick up and the Fed will raise rates) is what always drives a positively-sloped yield curve.

Squire said...

Money goes to the bonds with the best risk adjusted after tax after inflation return.

That is U.S.T's right now and for the indeterminate future.

Or go buy the Italian 10year if you'd like high nominal yields with high risk.

If you didn't go long stocks yet, you have to figure out the criteria where you can place your orders. Your stop loss is simply closing below 1100.

Socially, this recovery and the future economy is going to be built off the backs of the youth. But there will be enough people working to support those not working. It is only a matter of how well.