Tuesday, January 18, 2011

Reading the bond market tea leaves

This chart illustrates some enduring truths about monetary policy, Treasury yields, and the health of the economy, so it's worth revisiting from time to time. Right now it's sending a strong message: monetary policy is very accommodative, and poses virtually no risk to the economy. This unfortunately undermines at least some of the rationale behind the Fed's quantitative easing strategy (i.e., the economy needs help). Moreover, it also suggests that easy money today could be setting us up for rising inflation tomorrow, and that in turn could lead to another round of monetary tightening and the recession that would likely follow—though it could take several years for the unpleasant implications of this chart to surface.

The blue line represents the real Federal funds rate, using the PCE Core deflator as a measure of inflation (that being also the Fed's preferred inflation measure). The real funds rate is arguably the best measure of how "tight" or "loose" monetary policy is: a high real rate discourages borrowing by making it very expensive, while a low real rate encourages borrowing by making it cheap. When borrowing becomes intolerably expensive, the public's demand for money rises (rising money demand being the opposite of rising demand for borrowed money), and eventually collides with the Fed's efforts to make money scarce (by tightening monetary conditions). An effective shortage of money thus develops that typically results in a recession.

Based on this chart, one could argue that every post-war recession was caused by tight money. And in almost every case of very tight money, there was also a pronounced rise in inflation which created the need for monetary tightening. The late 1990s was the notable exception, since the Fed tightened aggressively even though the PCE Core rate of inflation never exceeded 2% from mid-1997 through mid-2001, gold and commodity prices fell, and the dollar rose.

The red line reflects the difference between the yield on 10-yr Treasuries and the yield on 1-yr Treasuries, what's known as the slope of the yield curve. Bond market math tells us that the yield on 10-yr Treasuries is the market's best guess as to the average of the Federal funds rate over the next 10 years. Investors in aggregate are necessarily ambivalent between keeping money in cash for the next 10 years or buying a 10-yr Treasury bond today—both strategies are expected to yield the same total return over time, because a steep yield curve means that the market expects the yield on cash to rise over time as the Fed tightens policy.

The fact that the red and blue lines move inversely most of the time confirms that the slope of the yield curve is a good indicator of how easy or how tight monetary policy is. When the Fed is very easy, the yield curve is usually very steep, because the bond market anticipates that the Fed will eventually have to raise rates significantly. Similarly, when the Fed is very tight, the yield curve becomes either flat or inverted, which is the bond market's way of saying that tight money today will be followed by easier money tomorrow. In short, monetary policy can't remain at extremes of tightness or looseness forever, and the slope of the yield curve is the bond market's way of saying how obviously easy or tight monetary policy is at any point in time.

So, when the blue line is very high (i.e., when the Fed is very tight) and the red line is very low (i.e., when the yield curve is flat or inverted) that almost always signals a recession ahead, because it means that money is becoming exceedingly scarce. Conversely, as is the case today, a low red line and a high blue line are typically indicators of a business cycle that is still in its early stages, and money is in relatively abundant supply. The unusually weak level of the dollar today confirms that dollars are relatively plentiful, and the high level of gold and commodity prices says the same thing.

The bad news here is that the Fed is likely repeating the errors of the 1970s, when monetary policy was on a roller-coaster ride and money was at times very cheap. Very cheap money in the 1970s helped fuel inflation, and today's cheap money is likely to do the same.

The good news is that deflation risk is non-existent; the economy is not starved for money; and there is every reason to expect the economy to continue to expand for the foreseeable future. Plus, there is still time for the Fed to reverse course before inflation becomes too high or too ingrained.


Benjamin Cole said...

Dow up another 50 today. Housing stabilizing.

And this in today-International Business Machines Corp. (IBM) reported record results, including its strongest quarterly revenue growth in almost a decade, an indication that companies are spending again on technology.

Really, if QE is bringing this on, I say pour it on, Bernanke, pour it on. Loosen up your suspenders, hunker down on the ground, and let is rip.

Inflation? Currently running under 1 percent, and we may be having deflation, if what the FOMC says is true--the CPI overcounts inflation by one percent.

Unemployed people and unemployed capital everywhere.

Empty warehouses for sale in Los Angeles--not seen that in 30 years.

Pour it on, Bernanke, we have a long way--and a long rally--in front of us. Pour it on, baby, pull all the corks out, tip the barrels over, gadzooks, set the whole damn house on fire.

This could turn out to be a great decade--not in Japan, but here.

Now, why would that be?

Public Library said...

One question: What impact does pinning the funds rate at zero have on this relationship.

It seems we are not in a 'normal' 1/10 slope environment.

either way, I think the Fed will error. Not on the side of caution, just flat out error as usual.

Another comment: Falling prices are not bad. We need to bury this fallacy.

Benjamin Cole said...

Public Library-

There is nation that holds dear your advice--or should I say a central bank. The Bank of Japan.

Even after 20 years of minor deflation, bond traders expect another decade of deflation in Japan.

In the last 20 years, Korea and China have emerged as the go-getter nations of the Far East. Japan is becoming a backwater.

The Japanese have stopped having families, the population is shrinking, home and property keeps going down in value, stocks are at one-quarter of 1990 levels. And they keep going down, down, and down some more.

I would say tight money is a great way to wreck a nation--once a nation full of talent and optimism, now settling down for a perma-recession. It even shows up in TV shows--Korea shows are livelier, more full of zest.

Buy hey--the yen has been strong, Very strong. And no inflation.

Way to go, Bank of Japan.

Scott Grannis said...

Public: I don't know why the Fed's almost-zero funds rate policy would change the message of the yield curve. If they were targeting the funds rate at 0.25% the way they used to, then cash would yield 0.25%. Currently, they are paying banks 0.25% on their reserves, and not surprisingly, cash and cash-equivalent yields are 0.25%. The yield curve is still driven by the market's expectation of the future funds rate.

Lori said...

Good work, Benjamin.

In this day of the information age, I'd rather have benjamins than use a public library.

Good on 'ya, Benjamin!

W.E. Heasley said...

“Moreover, it also suggests that easy money today could be setting us up for rising inflation tomorrow, and that in turn could lead to another round of monetary tightening and the recession that would likely follow—though it could take several years for the unpleasant implications of this chart to surface.”

Government induced bubbles can end on a very unpleasant note. If markets fail, governments fail too. Or in the classic words of Don Luskin: “Government is the only enterprise on earth that when policy fails, they just do the same thing over again, just bigger”.

Steve Fulton said...

Ben has decided that he'd rather have the 70's than risk the 30's. While he is setting up the next bubble (all rational people know that money at 0% gives you a bubble somewhere), that bubble bothers him less than the prospect of a depression. It's also telling that every single professional at the central bank rejects with all their heart that the Feds actions in '03-'04 had anything to do with the real estate bubble. That is what gives me so much pause.

brodero said...

From 1975 to 1980 non farm payroll
went up 17%....we are not going to
see the same thing today...that would mean job gains of 350 to 400000 a month for 5 straight years.....

Benjamin Cole said...


Bernanke, a student of the Great Depression, also an advisor to Japan in the 1990s, is a man of very deep intellect. Read FOMC transcripts and you will find out he is widely circumspect--believe me, he is aware of all the ramifications of every policy action he takes.

He has stated many times that if inflation gets too high, he can raise interest rates in 15 minutes.

That is yet another reason why I am utterly baffled by the fearmongering about inflation.

First, we may be in deflation now, if it is true that the CPI overstates inflation by one percent (which the FOMC staff and board say it does).

Secondly, we have slack galore in our economy--even Milton Friedman says QE fiorst leads to economic growth, then inflation--but only after slack is taken out of the economy.

Thirdly, think about open borders, and inflation. Things tighten up a bit, remember that goods and capital, and even labor, freely cross the US border.

If we have strong demand for, say, cars and labor, count on imported cars to go up, and more millions to cross the southern border (even yet, the Border Patrol is more for show than results). Ergo, very strong domestic demand leads to very strong growth, and not much inflation--I have never seen a right-wing economist acknowledge this fundamental shift ij the US economy from earlier epochs.

Goods pour through the LA-Long Beach harbor, people pour across the border.

How do you get wage inflation when South America lands on our doorstep in good times?

William said...

What about the rising inflation overseas: Asia, South America and even Great Britain. I realize that materials input cost make up a relatively small portion of each manufactured product (labor being the major cost I understand) but still materials costs have risen dramatically. Shouldn't all this increase be "imported" to the USA soon?

Steve Fulton said...


I guess I'd say that if the head of the central bank wants inflation, as he has publicly stated, he's going to get it. When asked about the large rise in rates since QE2 his response was "the stock market is up more than rates". So I get it--and I'm fully on board. I'm long the stock market, long commodities, short US rates and long the US rate curve (ie:steeper). All good so far. Ben is more concerned with repairing the consumer balance sheet (and with a somewhat broken monetary policy to consumer transmission mechanism he's gonna keep pouring it on) and I can't say he's wrong. What I can say with certainty is that this will create another bubble somewhere. Loose monetary policy is not a fix for tight/poor fiscal policy in the long run. I will stay long all the reflation trades that have been so successful as long as Ben has this mantra (except commercial property).
His statement tht he knows how to stop inflation dead in it's tracks when he sees it--is also true but it reminds me of a discussion between Glendower and Hotspur in Henry IV. Glendower says "I can call spirits from the vasty deep." Hotspur replies "Why so can I, or so can any man; but will they come when you do call for them?"