THE YIELD CURVE IS LYING TO YOU
By Lance Roberts, CEO, StreetTalk Advisors
You are being lied to. There is currently more than sufficient evidence that indicates that we are either in, or about to be in, a recession. The last time I made that statement was in December of 2007. In December of 2008 the National Bureau of Economic Research stated that we were correct. I don’t make statements like that lightly and, honestly, I hope I am wrong as this is a horrible time for the economy to relapse.
However, the reason that I bring this up is that there have been numerous analysts and economists stating that the economy cannot be going into recession due to the spread between various sets of interest rates. (For the purpose of this report we will focus on the spread between the 1-year Treasury bond and the 10-year Treasury note.) Historically speaking they would be correct and I will explain why.
The steepness of the yield curve has been an excellent indicator of a possible future recession for several reasons. First, the spread is heavily influenced by current monetary policy which has a significant influence on real activity over the next several quarters. When there is a rise in the shorter rate this tends to flatten the yield curve as well as to slow real growth in the near term. This relationship, however, is only one part of the explanation for the yield curve’s usefulness as a forecasting tool. The steepness of the curve also reflects the expectations of future inflation. Because economic growth is affected by the level and trend of both interest rates and inflation it is not surprising that the spread has historically been a good predictor of future recessions.
This time it could be wrong.
The issues with the spread between interest rates today are twofold. First, the U.S., via the Federal Reserve, has embarked upon an unprecedented series of policies to deliberately suppress the yield curve. Through outright purchases of treasuries through Permanent Open Market Operations (POMO) and Quantitative Easing (debt monetization) programs have been implemented to specifically target areas of the interest rate curve. Even the recent announcement of “Operation Twist” is specifically designed to flatten the yield curve to “help promote the demand for credit”. Therefore, since abnormal and artificial influences are being applied to the bond market to manipulate interest rates it removes the usefulness of the yield curve as a forward indicator of recessions.
Secondly, and most importantly, the economy is currently not operating under a normal economic environment. As we have discussed in recent missives the U.S., for the first time since the “Great Depression”, is undergoing a balance sheet recession. During the “Great Depression” beginning in 1929, the Total Credit Market Debt as a percentage of GDP rose substantially before eventually collapsing. We saw this phenomenon begin again in the 1980′s as total debt began to expand dramatically until the Total Credit Market Debt hit 380% of GDP in early 2009. We are now experiencing the deleveraging of those credit excesses which creates economic drag as money is diverted from savings and consumption to the repayment of debt.
Japan has been struggling with the same reality since the bursting of their real-estate/credit bubble and subsequent balance sheet recession. The government of Japan has implemented many of the same policies that Ben Bernanke has been foisting upon the US economy but to no avail. As a result Japan has been mired in a stagnating/declining economic growth environment for the last two decades with frequently recurring recessionary downturns.
The yield spread between Japanese bonds, much like we expect to happen here in the U.S., has remained positive due to government interventions since the beginning of their economic malaise some two decades ago. As far as a recessionary indicator goes – the yield spread has failed miserably.
Japan has been struggling with the same declining employment to population ratio, stagnating wages, an overburdened pension system and weak economic growth enviroment that currently faces the U.S. today. If that is the case then the economic future that has been laid out before us is not a bright one. The coming deleveraging of debt which will result in a needed cleansing of the excesses from the system will result in continued weakness in economic growth as consumers and businesses remain on the defensive. This defensive posture leads to deterioration in the demand for credit, stagnation of wages and lack of productive investment.
If the recent history of Japan is any reflection of the path that we have been set upon then we will likely enter a recession by the beginning of 2012. Of course, it will confound, confuse and surprise the mainstream analysts and media as the yield curve will most likely remain positive. As I stated before, I sincerely hope I am wrong, and that everything turns out for the best. Deep down I am an enternal optomist and believe in the innovation, ingenuity and passion that has made this country great. However, “hope” and “optimism” are not investment strategies by which we can successfully navigate the finanical markets today or in the future.
good article.
Good post. It is ironic that Uncle Ben is attempting to flatten the yield curve, which of course tends to signal a slowing economy. If he wanted to boost confidence, perhaps he should try to steepen the curve instead!
Can’t. Short term at 0 , significantly higher long term will destroy the mortgage market.
Only quick way out is inflation.
It could be argued that monetary policy is backward. Lowering rates could actually be deflationary for two main reasons. First, it reduces the amount of income in the economy. Secondly, interest rates are a cost of doing business. Lowering costs is deflationary.
sure, if you ignore income distribution as a factor.
If imagination is the prelude to lifes coming attractions (Einstein) then it is not too difficult to imagine the challenges for a “deleveraging” world economy. My only limitations in using my imagination is what Sovereign Central Bank responses will be – their responses will determine whether we have significant inflation (kicking the can down the road – no real solutions), stagflation (continued negative real interest rates) or deflation (across the board asset class depreciation) – all three will not end well!
Imagine if “all debt” oth personal and Sovereign debt was absolved!
Mr. Roberts,
A CEO telling us were being lied to supported by facts. The future looks better every day on this site.
Good Stuff Mr. Roberts!
I don’t support everything that Bernanke has been doing, but it is clear to me that he is trying to reduce rates for long-term loans like the 30-yr mortgage and business loans in order to stimulate the economy, especially the housing sector. I saw a forecast that within 3 weeks we should have a 30-yr mortgage rate down to 3.62%, it was on Bloomberg news. I doubt it will help much, but should help a little.
ya, it should help perpetuate more asset bubbles.
http://www.kansascityfed.org/publicat/econrev/pdf/4q97kozi.pdf
Predicting Real Growth and Inflation With the Yield Spread via the Kansas City Fed.
I agree with Lance Roberts on his post that the Fed has completely distorted the markets. The million dollar investment question is how do they restore it?
“The million dollar question is how to restore it”
How do we restore the markets? How do we restore confidence in the markets? How do we restore confidence in the Fed, Policy Makers and the FIRE sectors of the economy?
You don’t need a million dollars to answer this you just need to know how to type http://www.pragcap.com or http://www.ritholtz.com or http://www.hussmanfunds.com I could go on.
It’s free and it ain’t hard to do. You could go to other sites and get maybe not the best restoration project you wanted to answer the questions but better than what we have now.
If I lie to you consistantly about a little, most things or everything. There are only two ways to restore confidence. 1. I stop trying to control the outcome with lies and start telling the truth. It doesn’t matter how bad I think you will react to the truth. The TRUTH is the key to the restoration of markets, prosperity, freedom, good policy decisions and a Real honest life. Good or Bad we can set our sails in a direction based on the truth. I did not say it would be easy.
“it feels so good because it was F$$$ing hard”- Awolnation
But stay focused on solutions and action. Based on Truth.
2. If I keep lying and manipulating for my benefit, my constinuents or my own selfish political agenda or simply because I am covering up for poor policy than like any business owner must do. You must get rid of me. Some here would do it by force if they must or by legal and peaceful means.
At this point…legal and peaceful is the way to go. For now.
The Pragmatic Capitalist who read this site must figure a way to collectively help the unpragmatic capitalists to see why it’s important to know what the real problem is and the solutions to fix it.
If the unpragmatic capitalists are unwilling to be honest and stop making the problems bigger than we pragmatic have an obligation to remove the unpragmatic. It is our responsibility to cut off the limb before it kills the body.
Many of us here said the same thing when it was a finger 20 years ago. Then in 2000 it was a hand now in 2011 it’s the entire arm.
How hard is it to do the right thing…it doesn’t take a million dollars..it’s quite simple actually.
Agreed, great post. Challenges the conventional thinking from the perspective of a balance sheet recession. Wish we had more analysis like this.
Cullen, wanted to point you toward Krugman today, who had an interesting post showing how the Euro crisis has hit those countries with CA deficits rather than fiscal deficits. (Spain and Ireland were running surpluses before the crisis hit.) Seems to support the MMT & sectoral balance approach, doesn’t it?
Yeah, good piece by PK. We’ve been saying that for years. It’s directly out of the sectoral balances. His post on Ireland should also point out that their “recovery” is largely because of their trade surplus – again SB approach. PK should be onboard with us. I am a bit stunned that he can’t fully mesh MMT into his work….
Perhaps start with easier pickings.
John Mauldin has a big following and already gets “balance sheet recession”. You write well and can lead Mauldin to MMT as the logical explanation/solution.
Write his next book with him.
Why not put together a book outline for him and write a chapter? He’s a pop-economic writer, but MMT needs visibility more than “blessings” from Nobel prize winners. Once the conversation breaks more into the mainstream, the theory is strong enough to stand on it’s own.
MMT’s problem has never been losing the argument. The problem is getting into the conversation…
Why the U.S. is not Japan:
http://pragcap.com/why-the-balance-sheet-recession-will-not-last-as-long-as-japans
it’s funny, that right after this article was written,equities fell off the cliff. just a thought
Interest rates would be irrelevant if we did not have a government enforced private money monopoly. Why? Because if interest rates got too high then new money supplies would be created to drive them down.
But let’s continue to think we have a “free market economy” while the most important part of it, money creation, is a government backed and enforced cartel?
I think the issue in the US is not with government money monopoly (is there an advanced or emerging economy without a central bank? ), but with the public/private nature of the Fed. It should be all government and serve to national interests.
It should be all government and serve to national interests. dimm
What is the “national interest”? Is it not what the public would freely choose? Would the Soviet Union have invented the “I-Pod”?
I see you chose to ignore my question, so I’ll ask again.
Is there an advanced or emerging economy without a central bank? That is what you are suggesting, right ?
Is there an advanced or emerging economy without a central bank? dimm
Not to my knowledge. But is there a country today that is not having severe economic problems?
That is what you are suggesting, right ? dimm
For sure. The government should have nothing to do with private money creation. The government should content itself with creating, spending and taxing its own fiat. As for the private sector, if it cannot create money solutions that do not require government coercion then the free market is vastly overrated.
But is can, right ?
Corporate stocks, bonds and all other financial instruments issued by the private sector are just that. The private sector is free to issue and trade them.
What am I missing?
What am I missing? dimm
All the government privileges for FRNs:
1) The capital gains tax is measured in FRNs. Thus if the real value of FRNs goes down then other forms of money such as common stock register a phony capital gain. This is called the “stealth inflation tax”.
2) A lender of last resort, the Fed, exists to lend legal tender to the banks as needed to clear their checks.
3) Government deposit insurance for the banks.
4) The US Government borrows and pays interest for FRNs from the public and banks.
Furthermore, the proof is in the pudding. I see no private currencies in use anywhere. Instead I see people driving up the cost of gold – a silly, primitive, obsolete money form.
“2) A lender of last resort, the Fed, exists to lend legal tender to the banks as needed to clear their checks.”
The Fed does not provide more than daylight unsecured loans to banks to enable them to clear their cheques. All other loans are asset swaps. MMT repeatedly says that bond asset swaps of any maturity make no difference.
The fed provides liquidity rather than ‘lends legal tender’. Ie it takes away and it gives. Importantly even in an epic financial crisis you have to have something worth giving to get anything.
The fed provides liquidity rather than ‘lends legal tender’. Ie it takes away and it gives. andrewjudd
Call it what you will; it is government privilege for the banks. Furthermore, without US Government borrowing, another government privilege for the banks, the banks would have no 100% secure assets to swap for Fed liquidity.
I’m off like a traveling doctor to visit with the people. One house at a time.
Then off to play with my son and see how funny he can make me feel.
Thanks for turning the light on the lighthouse you call the TPC. I did manage to do some damage to my vessel this week(Emerging Markets Submerged) but it was Captain error you tried to steer me away from that rock in the sea.
Were still ahead of schedule to our destination and I noticed many shipwrecks this week during our passage.
It’s too bad they ignore the lighthouse they call the TPC.
(that was realllyyy cheeeesssy but…the truth)
I worked up an article on this very topic around 18 months ago.
http://merrillovermatter.blogspot.com/2010/06/is-steep-yield-curve-leading-us-astray.html
I think ‘VII’ hits the nail on the head, the lying and manipulation work for a while but there is a diminishing marginal return for each unit of lying. Eventually it just doesn’t do anything any more. Are we hitting that point?
Indeed, it makes a lot of sense to compare our spreads to Japanese. And those provide very little, if no indication of recession. Actually, current spread contraction may well qualify as recession indicator.
Looking at the GDP chart, it is interesting to see how may negative quarters there have been in Japan over the years that were not counted as recessions. It suggests that the US could also be in for regular negative GDP quarters that are not technically recessions as they will only be singles.
I talked to some bankers yesterday. And even they hate this 0% forever interest rates environment. They can’t make any money on lending. If even bankers hate FED polcies, then what is the point of all this FED illusionism?
I agree with the poster above – long term low interest rates in a BS recession are deflationary because they reduce the amount of money flowing. Everything is happening at a glacial pace, there is no hurry to borrow and there is no money to spend because it is impossible to save at rates below inflation.
The entire episode dating back to 1983 tells me that there simply is t o much inbreeding within capitalistic societies.
Fine. So what? A whiter shade of pale is not a hard call at this point. Please explain the length and depth of the recession and where we will be 12, 24 months from now.
Is the curve telling different stories? Lance seems to be saying that recession is unavoidable but not yet, something the current steepness of the curve does not say. And yet, yields on 10+ treasuries have fallen to levels which indicate current economic catastrophe (as TPC has said). So which one is it?
If the curve flattens, this time it will most likely be because the long-end comes down. Based on what TPC has taught us about QE and Fed purchases of longer duration treasuries by quantity, the Fed’s intentions will be just as effective as last time. Makes me wonder if the Fed will provide some level of support for yields?
It seems to me the bond market is just as depressed as the rest of the developed world, recognizing the slow and arduous road ahead. Mediocre growth with lots’o'risk.
Thank you for this wonderful article, I have been of the same opinion for some time. If I may add something to it’s discussion.
We have been in a secular bear market that started in 2000 with the bursting of the dot-com bubble, of Alan Greenspan’s making. Instead of letting the system clear, we not only doubled down, but when the housing debt debacle blew up in 2007,Ben Bernanke,like Greenspan before him,”had to do something.”
I would posit, if we had taken some pain in 2000 and started the deleveraging process then, we could have avoided a lot of the housing bubble all together. I know this is somewhat “Monday night Quarterbacking” if that’s the correct term, but it goes to a M.O.
Now we are here,today, after massive progressive stimulus / spending with nothing to show but off the chart debt levels that are higher today than at the top in 2007.
We are like wall street junkies looking for more QE, which only juiced risk assets at the death of the working mans standard of living,(dollar debasement)and continued mis-allocation of capital all over the world.
We now have a class warfare struggle going on with real unemployment rates closer to 18 % as opposed to the official U-3 9.1 %.
The unions and Obama are out to cast anyone with a differing opinion of our current predicament as “Racist” and “Greedy Millionaires” who care nothing for “Working men and women”,this is laughable because the only working people both Trumka and Obama are courting are union members!
The rank and file are the best paid members of society(full disclosure,I am a former Local 100 employee) and have the most generous benefit’s there are to be had!We have a debt bomb at every level of union pension obligations today due to years of progressive politician’s of “BOTH” parties unrealistic promises to get elected and re-elected.
Unless the union membership, state,local and federal are willing for the good of the country to give back at least 50 % of all wages and benefits,we will never dig our way out of this quagmire.
I feel strongly that the current political divide,between those that have,(unions)and those that do not(the rest of us who are lucky enough to be employed)is going to “Collapse the system” if it is not addressed promptly.The only way left to level the playing field is a depression that would cleanse the excess out of the system.
I see no chance at all of Trumka and Obama saying to the union rank and file that if they don’t give back 50% of everything, the coming depression will net them 100 % of “nothing”,I just don’t see it in their nature!
This is what is referred to as the “Cloward and Piven” “Collapse the system” mode! I believe it is being followed today by this administration.
The President is a huge fan and follower of Saul Alinsky and his book,”Rules for Radical’s”, the book is dedicated to the worlds first radical, SATAN!
These are hard concepts to get a law abiding citizens mind around, but they need to at least be explored,given the events of today.Thanks for the opportunity to be heard.
May the good lord watch over this fragile little experiment in freedom we call America
God Bless The Virtuous
Jerry
You’re actually suggesting that Obama is a Satanist and that the solution to our problems is for a small group of middle class Americans to give up half of their pensions. You know, that edit option is there for a reason…
“Unless the union membership, state,local and federal are willing for the good of the country to give back at least 50 % of all wages and benefits,we will never dig our way out of this quagmire.”
Excellent solution in our race to the bottom. Now that that’s resolved, use your advanced trouble-shooting skills and redirect your efforts toward protesting abortion clinics and mosques. Be sure to ask everyone for their “papers” as they walk by. We’ll have this country back on track in no time.
Really comparing our current dilema to Japan simply under appreciates our condition. This type of analysis is why i am so bearish. I dont recall any time in he past 20 years when nearly every economy on the planet was simaltaneously facing a downturn.
While I’m also reluctant to compare Japan’s “Lost Decade” conditions in a simplistic way to the U.S., I take the point of the article to be simpler, which I can accept, which is that spreads between various interest rates can no longer be assumed to be indicative of strong economic performance. Although both Japan in the 90s and the current U.S. condition are characterized by significant “Total Credit Market Debt” (to use the author’s phrase), the underlying reasons for this in each country may be different–the article does not explore this. The analogy is there, and it is confusing, but the article’s main focus may not be on the analogy, per se. Just my interpretation; I could be wrong.
And they are lying to investors in refusing to disclose the market value of assets held by publicly listed companies, even on some sort of moving average or limited write down per annum or other smoothing basis.
The fall in yields rising prices of existing higher coupon bonds is a huge opportunity to banks to make large profits on selling bonds bought for yield but funded with short term deposits/notes/bonds. It is also a huge danger to those who now buy those same bonds or new issues at the current low rates. Any recovery/inflation resulting in higher interest rates will crucify their capital value. However looking at Japanese 10 year bond yeilds they have not been above 2% since July 2000, so maybe US 10 year bonds are now in their normal range for the next 10 years!
1. The US is already in a recession because inflation was understated and inflation must be subtracted from GDP which was – IMO – overstated. One even can make the case the US never came out of a recession in 2009 and/or 2010.
2. Who says that central banks are capable of manipulating markets for a long period of time ?
3. The FED is trying to push long term rates down and short term rates up. That would, yes, effectively, flatten the yield curve. But again, that wouldn’t make a difference. Mr. Market is always more powerful than the FED.
4. When the FED is buying the long end of the curve then I take the other side of the trade: Sell the 30 year bond (future).
5. The japanese yield curve remained positive signaling to me some sort of “”muddling through”" economy.
6. I would focus on REAL interst rates as well. Say, an interest rate is 2% and inflation is -4% (minus 4) then the REAL interest rate is 2-(-4)= +6%. Ouch !!!
This raises some very interesting questions:
1. Why would the FED specificly target the 10 and the 30 year rate ? And why now ?
2. Is demand for those bonds drying up in spite of MMT ?
3. Does the FED know anything we don’t know ? have foreigners begun selling those bonds ? Were they scared out of their wits by the shrinking trade deficit ?
4. Is the shrinking trade deficit in combination with the growing federal budget deficit finally starting to bite Uncle Sam’s bacon ? Because foreigners are running out of USDs and therefore demand is drying up ?
5. Is the FED’s balance sheet so out of whack that only buying T-bonds (and not selling anything) would blow the FED “”out of the water”" ?
1. What if long duration rates would go up in stead of going down from now on ? The FED buying those bonds is the opportunity for investors to offload those bonds onto the FED’s balance sheet. Then we also would have a yield curve becoming much steeper. And then that would truly signal a “”recession”".
2. Comparing Japan in the last 20 years with the US of the today is – IMO – comparing apples with oranges.
agreed that innovation alone will not counter the much bigger macro economic forces in this story. The Nikkei is now back at the level where it was 30 years ago, just about when Sony gave the world its very first version of the Sony “Walkman”. Audiocassettes that is… Needles to say that in those 30 years Japan has not stood still in terms of technology and innovation. Only the Nikkei and corporate earnings have stood still.
- You are in or about to be in a recession.
- This time it could be wrong.
nice, subtle shift of conviction. Because you don’t have a chrystal ball up your arse after all.
Normally the yield curve leads the economy.
Normally.
Once people realize this is not a normal time, they will realize that this time
the economy is going to lead the curve.
Down.
Long end first.
Turning Japanese, I really think so.
Greece is going to default out of the Euro, one way or another – if the current gov’t doesn’t, the Greeks will replace them soon – the German-enforced austerity is collapsing their economy. This will be the Lehman of 2011, and push us from Lesser Depression into Great Depression 2 territory. Since US Republicans have painted themselves into a corner, economics-wise, it becomes irrelevant who’s president, since any “stimulus” will remain politically untenable. Short of spending+jobs on a WWII level, GD2 will be more or less permanent. I don’t think there will be a “recovery” – I think in ten years we’ll look back and think of where we are now as a peak.In other words, where we are right now is as good as it will ever be again in our lifetimes – scary, scary thoughts.
In related news, PK thinks you are right! (but…overly complicated?) http://krugman.blogs.nytimes.com/
“In related news, PK thinks you are right! (but…overly complicated?)”
PK and his usual snark. It gets old. Economists are worse than politicians these days. I’m about to take everyone hostage and lock them up in my basement until there is agreement. And I’m not opposed to waterboarding at this point. If that doesn’t work, I’ll talk about my cat.
@Trixie,
“And I’m not opposed to waterboarding at this point. If that doesn’t work, I’ll talk about my cat.” You seem to be saying that most people would regard waterboarding a LESS serious torture than listening to someone talking about their cat…I’m shocked, shocked, I tell you, that you could even think such a thing. Why, our little Toffee is just ten months old, and she is the light of our lives for my wife and myself. We have video of her doing just the cutest things, I’ll send you the links…Oh, wait…Sorry – I begin to see your point.
I must have missed this response. And I just blew liquids through my nose upon reading it. Well played.
You are my soul mate. NO ONE else gets it.
Question for anybody:
“We saw this phenomenon begin again in the 1980′s as total debt began to expand dramatically until the Total Credit Market Debt hit 380% of GDP in early 2009.” What would the total dollar value of this debt be, and how would it compare to overall global economic growth since the same year in the 1980s during which such debt began to escalate? Then, what conclusions might one draw from such a comparison? Could total U.S. debt (private plus public) be understood to have been the main catalyst for economic “growth” worldwide, as opposed to the usual causes of growth, such as increases in productivity due to IT, etc? How anemic has been aggregate demand on a global scale since the early 80s that a total debt value of 380% of 2009 GDP was structurally necessary over these past few decades to stave off a Great Depression coming out of the economic crises of the 1970s? Were the 70s crises ever really, truly resolved?