Friday, October 21, 2011

Yield curve signals growth (cont.)




Further to my post of yesterday, here are some more measures of the shape of the yield curve. We know the Fed is trying to manipulate the bond market, first by QE, and second by Operation Twist. 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's policy target is the overnight rate), it has very little control over the yield curve from 5-10 years and 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.

Today, we know the Fed can't stay at zero forever; at some point the economy will pick up and the Fed will begin increasing short-term rates. Looking at the forward Treasury curve, we see that the market expects 3-mo. T-bill rates to rise from zero today to 0.71% in two years. 2-yr Treasury yields are expected to rise from 0.3% today to 1.3% in two years. 5-yr Treasury yields are expected to rise from 1.1% today to to 2.2%. In short, a positively-sloped yield curve is driven by the expectation that short-term rates will rise in the future. That is always the case when the yield curve is positively-sloped.

As the top two charts show, despite the Fed's attempts to depress long-term interest rates, the curve out to 30 years remains very steep by historical standards. That is fully consistent with the expectation that the economy will improve. It is not at all consistent with the view that we are on the cusp of another recession. If the latter were the case, the yield curve would be flat, especially in the 2-5 area. Yet even that part of the curve, where Fed expectations are very strong drivers of yields, the curve still has a definite positive slope. No matter how you look at it, the market fully expects things to improve in the future, not get worse.


6 comments:

Benjamin said...

"Today, we know the Fed can't stay at zero forever; at some point the economy will pick up and the Fed will begin increasing short-term rates."

Probably, but not for sure. The experience of Japan illustrates a central bank can go to zero, or nearly so, and nothing happens. They just stay there. For 20 years and counting.

As measured by the core CPI, the USA is showing inflation, of about 2 percent. Yet the TIPS and real estate markets anticipate scant inflation, if that. It may be that the CPI overstates inflation, as many very conservative economists have contended in the past.

Central bankers often yield to a peevish fixation on inflation, an unhealthy obsession often shared by American conservatives.

The more sensible goals of economic growth, innovation, commercial freedom and prosperity often become secondary, especially for members of the bondholding class.

Tough to call this one. The Market Monetarists have gained a great deal of traction of late, and perhaps Bernanke/Fed will see their way to growth policies.

Dr William J McKibbin said...

Growth would be moving faster but for the pending defaults along the southern flank of Europe and at the state and municipal level in the US -- these defaults will have to be transacted in some form before a true recovery can take root -- my guess is the growth will continue drip forward, but that bond rates will remain near zero for a couple of more years -- also, US employment is likely to drop dramatically as state, municipal, and perhaps Federal jobs fall off the books to the tune of at least another 1 million job losses in the next couple of years -- what this all means is that we are in a trough that will continue for a few years -- the trough creates real buying opportunties and everyone should be converting everything they have saved into equities and real estate while prices are cheap -- jobs will become much more scarce in the coming years, and only those with productive skills will be able to sustain employment -- skills will trump age and experience throughout the coming decade -- we are in a Main Street depression that the Federal government and public corporations have been methodically shielded from -- those who live on entitlements, government pensions and employment, or have only experience on their resumes will find the coming years dreadfully hard -- the long-term unemployed in America will likely never work again in the USA -- no one should think that prosperity for all is right around the corner -- the cloud of depression has decended upon ordinary citizens of America and we should all take care of each other in the coming tough years...

PS: In my home state, our capital city of Harrisburg has already declared bankruptcy -- I expect to see hundreds of US cities and towns fall into some form of bankruptcy or default in the coming 24 months...

PPS: Dividend and rent paying equities and real estate are a real value right now...

Benjamin said...

The rally today highlights another positive--we are finally getting out of extraordinarily expensive wars, that were adding trillions of dollars to the national debt.

Some say Iraqistan is a $4 trillion undertaking.

Obama today says we are out of Iraq Jan. 1 and 2014 on Afghanie (the longest and among the most futile wars in US history, and we will probably lose there, much like Vietnam).

Getting of the expensive Iraqistan dunghole can only be a huge positive for American business.

Aside from Ron Paul and Pat Buchanan, the fantastic cost of these wars is rarely alluded to, I don't know why. I guess it is not politically correct.

Dr William J McKibbin said...

Benjamin, I doubt any of these wars are truly over -- the US has maintained troops on permanent occupation duty in places such as Germany, Italy, Korea, Okinawa, Japan, Cuba, and other places for decades -- neither the Republicans or Democrats appear eager to cut defense spending by the way -- I suspect that hundreds of thousands of US troops will remain overseas for many decades to come -- however, I for one would like to see a serious debate in the US about our military strategy overseas -- the US spends more in defense spending today than the rest of the world combined (!) -- that's too much...

Public Library said...

Making a statement that the Fed can't stay at zero forever is like saying house prices will never fall nationally. Time to change the inputs into the models to accommodate for exactly such an occurrence.

Benjamin said...

Dr William:

The ungodly waste of taxpayer money on a $1 trillion-a-year federal agency complex--the DoD-VA-Homeland Security miasma--will not be undone overnight.

But there are conservatives, such as Pat Buchanan or Ron Paul, who call it straight.

It is sad that what you hear in right-wing echo chambers is true--Solyndra was an abomination for example--but never about defense boondoggles or the USDA, which are far, far larger usurpations of taxpayer money.

For that reason, the modern-day GOP will never balance the federal budget, or even come close.