The yield curve says "no recession"

Because of the way the Fed conducts monetary policy, the Treasury yield curve can tell us a lot about the market's expectations for economic growth and inflation. Currently, the yield curve is saying that the market expects to see modest economic growth of 1 - 2% for the foreseeable future, with modest inflation as well, in the range of 1.3 – 1.6% per year over the next five to ten years. 

Central banks have only three choices when it comes to policy tools. They can either control the money supply, interest rates (short or long, but not both), or the exchange rate, and only one of those at a time. After choosing one, they must accept the market's verdict on the others. Any attempt to control more than one of these monetary variables will inevitably end in tears, as the central banks of Argentina and many other developing economies can attest.

The Fed long ago decided that it would conduct monetary policy by controlling overnight interest rates (i.e., Fed funds). For many years the FOMC would add or subtract reserves from the banking system in order to keep the Fed funds rate (the rates banks charge each other to borrow reserves) at or near the Fed's target. Beginning in late 2008, the Fed modified this strategy, since it purposefully supplied trillions of excess reserves to the banking system. With a super-abundance of reserves, banks essentially have no need to borrow more, so the traditional Fed funds market no longer exists. The Fed solved that "problem" by deciding to pay interest on excess reserves (IOER), and that rate became the de facto Fed funds rate, enforced recently by allowing non-bank institutions to enter into reverse-repo transactions with the Fed and thus effectively earn the same rate that major banks can by holding excess reserves at the Fed.

The evidence to date is still relatively scant, but it looks like things are proceeding according to the Fed's plan. Libor, the rate that the market demands for lending to banks instead of to the Fed, is trading around 60 bps, which is somewhat higher than the 50 bps that banks earn by lending money to the Fed (i.e., by holding excess reserves at the Fed), and that makes sense. In other words, the Fed appears to have found a way to target the overnight risk-free rate by simply changing the rate it pays on excess reserves. The Fed's primary tool—short-term interest rates—hasn't changed, but the method of implementing it has.

Regardless, it is important to remember that the Fed can only control short-term rates. As three Quantitative Easing episodes from 2008 through 2014 demonstrated, despite the Fed's massive purchases of notes and bonds, 10-yr Treasury yields actually rose (see chart above). This put the lie to the Fed's professed objective of buying notes in order to artificially lower yields and thus "stimulate" the economy. As I've explained many times over the years, the real purpose of QE was NOT to lower bond yields and stimulate the economy—the real purpose was to supply the world with more risk-free monetary assets (aka bank reserves, which, with the addition of IOER, became T-bill substitutes) in order to satisfy the world's intense demand for money and safe assets in the wake of the 2008 financial crisis. The Fed did this by buying notes and bonds and "transmogrifying" them into T-bill equivalents. This was neither stimulative nor inflationary, since the Fed was simply supplying the money that the market wanted to hold.

Since the Fed can only control short-term rates, observing longer-term rates can tell us a lot about the market's expectations for the future of Fed policy. 2-yr Treasury yields, for example, are equivalent to the market's guess as to what the Fed funds rate will average over the next two years. The current 2-yr yield of 0.8% is a function of the market's expectation that the Fed funds rate will rise from 0.5% today to 1% or so two years from now. This expected path of the funds rate is consistent with a forecast of modest economic growth and low inflation. It is not consistent with an expectation of recession.

Market equilibrium tells us that, collectively, investors at any moment in time must be indifferent between earning the prevailing overnight risk-free interest rate for two years or investing their money in a 2-yr risk-free security and holding it for two years. Ditto for 5-year yields. But when it comes to 10-yr yields, the analysis becomes trickier, since the market invariably demands some kind of premium for locking in yields for such a long period. Nevertheless, looking at the difference between 2-yr and 10-yr Treasury yields can tell us a lot about what the market expects from the Fed over the next several years.

The two charts above show the history of 2- and 10-yr Treasury yields and the difference between the two, which is the slope of the yield curve. Note that the slope of the yield curve typically flattens or inverts (becomes negative) in advance of recessions. This is the bond market's way of saying that emerging weakness in the economy is putting a lid on the Fed's ability to raise short-term rates, and that it is increasingly likely that the Fed's next move will be to cut, rather than raise, rates. The current slope of the yield curve is not unusual at all, and is typical of the middle part of a business expansion. The market doesn't believe the economy is going to be weak enough to warrant lower short-term rates for the foreseeable future.

The chart above compares the nominal yield on 5-yr Treasuries with the real yield on 5-yr TIPS, the difference between the two being the market's expected annualized rate of inflation over the next 5 years, currently 1.3%. This is relatively low, but not unprecedented and not of great concern. Indeed, I would be thrilled if inflation were to average 1.3% per year for the foreseeable future. Inflation is pernicious, penalizing savers and rewarding borrowers, and is effectively a backdoor way for the government to avoid the full consequences of its spendthrift ways. The lower the better, in my book.

The chart above compares the real yield on 5-yr TIPS with the 2-yr annualized rate of real GDP growth. These rates tend to track each other, with real yields on TIPS tending to be a point or so less than the economy's growth tendency over the past two years. That makes sense: you can lock in a risk-free rate of return on TIPS, or you can take your chances with the real growth of the economy. Risk-free yields should always be less than riskier returns. As I read this chart, the market is expecting real GDP growth to be between 1 and 2% for the next few years, which is a bit less than the 2.1% annualized growth of the economy in the current business cycle expansion.

There's not much to get excited or worried about here. The market is (not atypically) projecting that recent trends in growth and inflation will persist for the foreseeable future.

Meanwhile, as the chart above suggests, this continues to be the weakest post-war recovery on record. If this had instead been a "normal" recovery, the economy today would be about 15% ($2.8 trillion!) bigger. Rather than worrying about a recession, we should be obsessed with finding ways to get the economy back on its long-term growth path. (Hint: smaller government, reduced regulatory burdens, lower and flatter marginal income tax rates, and much lower corporate tax rates.)

It's the unrealized growth potential of the economy that is the big news, not the risk of recession.

More reasons to avoid despair

Three weeks ago I noted that although there was no shortage of bad news out there, there was reason to avoid despair. In this post I offer more than a dozen charts which make the case for remaining optimistic that things are getting better—albeit slowly—not worse.

Housing prices have been rising for almost four years now, and they were up over 5% nationwide in the year ending last November.



New home sales continue to rise, and probably have a lot of upside left.

Housing starts are likely to continue rising, as suggested by relatively strong builder sentiment and rising building permits. The housing sector is one of the economy's strongest.



As the chart above shows, new applications for home mortgages (not including refis) are up 40% from the levels that prevailed during 2014. 30-yr fixed conforming mortgage rates currently are 3.7%, and with the exception of 10 months in late 2012 and early 2013, have never been lower. If confidence continues to improve, there is every reason to think the housing market has plenty of upside.

Gasoline prices haven't been this low for a long time.

In response to substantially cheaper gas prices, vehicle miles driven have risen almost 5% since oil prices started to fall in mid-2014. Consumers and businesses are definitely responding to cheaper energy prices. Cheaper energy prices are likely working to stimulate more activity throughout the economy that has yet to show up in the statistics.

As the chart above shows, the big drop in real gasoline prices (shown here as a rising red line) has been an important source of rising consumer confidence.

A survey of small businesses shows that hiring plans continue to improve.

The U.S. consumer is far from being tapped out. Indeed, credit card debt as a percent of disposable income (the red line in the chart above) hasn't been this low for decades. After years of deleveraging, consumers are just beginning to return to the credit well.

This index of industrial commodity prices (CRB Raw Industrials) is up over 4% in the past two months. This leaves commodity prices more than 90% above their lows of late 2001, and suggests that demand is starting to pick up and/or supplies are starting to tighten. Despite the global weakness sparked by the slowdown in China, prices are not going down a black hole.

Bank lending to small and medium-sized businesses has been rising at double-digit rates for over five years. This reflects increased confidence on the part of businesses and banks.

After five years of very slow growth (2008-2013), bank credit is expanding at a more normal pace, up over 8% per year for the past two years.

Confidence is rising, there is no shortage of money or credit, businesses are hiring, cheaper energy prices are stimulating more activity, and the housing market is firing on all cylinders. This is not what you would expect to see if the economy were teetering on the brink of another recession.

Don't forget the TED spread

This blog has paid a lot of attention to swap spreads over the years, in the belief that they are good coincident and leading indicators of systemic risk and economic and financial market health. Swap spreads have been very low of late, despite the turmoil in the oil patch, which has sent spreads on high-yield energy-related debt to levels not seen since the height of the 2008 financial panic. I think that means that the problems in the oil patch are not likely to spread to other areas, in the way that problems with mortgage-backed securities spread to the global economy in 2008. Why? Because swap spreads tell us that liquidity is abundant (thanks to QE) and the financial markets are thus able to fulfill two of their primary roles, which is to spread risk around and, through the magic of markets, find prices that match sellers to buyers, and that balance the supply of and the demand for commodities such as oil. Markets can almost always solve problems if left to their own devices, and if central banks respond to crises by providing needed liquidity.

A related indicator, lost in the QE shuffle of the past 7 years, is the TED spread, which stands for the difference between the yield on 3-mo T-bills and 3-mo Libor (T-bills/Euro Dollars). It is a direct measure of the premium that investors demand for accepting the risk of loaning money to a bank rather than to the U.S. Treasury. 

As the chart above shows, that spread soared to more than 300 bps at the height of the 2008 financial crisis, an indication that the world was deathly afraid that more banks would collapse in the wake of the Lehman failure. The TED spread also soared in late 1987, as the S.E. Asian currency crisis blossomed and entire banking systems overseas were threatened. The spread rose for years prior to the 2001 recession, accurately signaling developing problems. In contrast, the current level of the TED spread, 34 bps, is about what it equals during periods of relative calm.

The chart above shows the evolution of the TED spread (the bottom half of the chart) and its components (top half). What it also shows is that the Fed's efforts to raise money market rates through its IOER reverse repo program are working. 

This last chart shows just the yield on 3-mo T-bills, often referred to as the bedrock risk-free rate for the entire world. That this rate has risen from zero to 30 bps against the backdrop of a global financial panic in recent weeks is notable, to say the least. If global conditions were truly calamitous, the Fed's efforts to raise short-term rates arguably would have proved futile, as there would have been an overwhelming demand for the safety of 3-mo T-bills. [Chart corrected from initial publication to show a closing yield of 0.3% rather than 0.24%.]

Bottom line, the underpinnings of financial markets look reasonably solid, and that offers the promise that the turmoil in the oil patch will be resolved without plunging the world into another 2008-style crisis.