December 26, 2010
Changes in the yield curve
The bond market sees an improving economy.
The yield curve has shifted up and steepened over the last 4 months, which I read as a perception that things are not quite as dreary as they appeared a short while ago.
On the other hand, that still leaves the overall level of interest rates a little below where they stood a year ago. Essentially what happened this fall was a reversal of much of the pessimistic sentiment that had been developing in the first 8 months of 2010.
Much of the flattening and lowering of the yield curve in the first 8 months of 2010 was due to a decrease in inflationary expectations. These too have come back up, as the graph below of the spread between nominal yields and those on Treasury inflation protected securities reveals.
Note that since the nominal rates are below the levels of a year ago while expected inflation rates are back where they were, this means that real interest rates have come down. And although the inflation rates implied by the above curve for the next 5 years remain a bit below what the Fed would ideally aim for, this is a better picture than Bernanke was looking at last August.
One goal of the Fed's second round of quantitative easing begun at the start of November was to flatten the yield curve. That obviously didn't happen, and I discussed some of the reasons why a few weeks ago. A second goal was to increase inflationary expectations, which was achieved.
Even so, all we've done is moved back to about where we were a year ago. And a year ago, if you recall, things really weren't that great.
But at least now we're moving in the right direction.
Posted by James Hamilton at December 26, 2010 07:48 AMdigg this | reddit
Economics in practice seems to regularly offer conclusions that are based in counter-factual assumptions(necessarily perhaps). This for example:
"One goal of the Fed's second round of quantitative easing begun at the start of November was to flatten the yield curve. That obviously didn't happen..."
The counter-factual assumption here seems to be the possibility that that QEII may have kept the yield curve from getting steeper. Which, would suggest something other than the conclusion drawn from assuming that nothing happened. The actual influence of QEII on the yield curve could thereby be misinterpreted altogether. Perhaps, for example, Bernanke & Co. anticipated the steepening of the curve and then underestimated the amount of stimulus needed to reach the desired result. QE is still somewhat experimental after-all? Or... maybe the political pressure against QE by the ROW did not allow the program to be as large as what was thought to be needed, and so, a compromise was necessary?
In any case, it seems that without knowing what would have happened without QEII, that it is possibly misleading to draw conclusions without at least some consideration of the alternative possibilities.
Posted by: rayllove at December 26, 2010 09:33 AM
Nice charts, thanks. Nominal oil was $66.33 in December '09. Brent spot closed Friday at $92.99.
I know I am being a seasonal Grinch. But I essentially learned this from you (not the Grinch part).
Oil prices are in the range where their drag on consumer demand, especially durables and perhaps housing, will become perceptible. This will add to the end of fiscal stimulus as being a major worry in 2011 for the U.S. economy.
Posted by: Steve Bannister at December 26, 2010 09:42 AM
Isn't the question whether or not the yield curve is flatter than it otherwise would be? The big tax cut bill surprised a lot of people who thought Congress was going to get tough on the deficit. Maybe with that and without QE2, the curve would be even steeper?
Plus there's the problem that while QE2 has a direct effect on rates, it also has an indirect effect because of how it changes other market participants perceptions. For instance, the crowd worrying about big inflation probably expanded some.
It seems like the Fed was probably right in the 1940s to target rates, not purchases. But the success of that policy might have depended a lot on the patriotism of bond buyers. Good luck with that now-a-days.
Posted by: Bob_in_MA at December 26, 2010 09:57 AM
This is a stupid question, but could you mention the source you use for this data? Thanks.
Posted by: Random Student at December 26, 2010 11:15 AM
Random Student: Click on the last link in the captions under the figures.
Posted by: JDH at December 26, 2010 11:26 AM
The bond market saw that constraints were underestimated in Aug 2009 and wants a higher yields today in compensation.
Posted by: Matt Young at December 26, 2010 12:05 PM
It seems appropriate to me that you mention here, as you did ~Dec 14, that the Treasury is issuing longterm debt in greater quantities than QE2 is monetizing it.
That certainly clouds any conclusion about what the 'market' sees.
Posted by: Bryce at December 26, 2010 01:14 PM
Come on James, yields were down because of the European mess. That is CLEAR now. Little to do with the US economic performance. Matter of fact, they are still much to low considering the "improvement" seen in the last 6 months. They should be higher yet and maybe will during the January-March timeframe.
Yields will chase the financials with them all heading toward zero when the market finally gives up.
Posted by: The Rage at December 26, 2010 01:21 PM
"One goal of the Fed's second round of quantitative easing begun at the start of November was to flatten the yield curve."
Pardon me, but really?
I can't find anything in the FOMC's official statements indicates that was the purpose. And if that is the purpose, why is that only 6-29% of the puchases are in 10 year or longer terms?
It seems to me (despite the fact that Bernanke did nervous cerebral contortions denying it on 60 Minutes) that the real purpose was simply to print money. There are actually other monetary transmission mechanisms than just interest rates (e.g. see Mishkin).
But the sad fact remains that most of this new money will end up as excess reserves anyway thanks to IOER.
Posted by: Mark A. Sadowski at December 26, 2010 01:30 PM
Mark A. Sadowski: See for example Bernanke's statement on Oct. 15:
For example, a means of providing additional monetary stimulus, if warranted, would be to expand the Federal Reserve's holdings of longer-term securities.5 Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery.6 A similar program conducted by the Bank of England also appears to have had benefits.
Posted by: JDH at December 26, 2010 01:45 PM
True, but Bernanke was speaking for himself and not the FOMC on that particular occasion. And I see little evidence from FOMC statements, from the actual implementation of QE II, or, indeed, from the results that support the notion that the purpose was to flatten the yield curve.
Posted by: Mark A. Sadowski at December 26, 2010 01:56 PM
Reading a whole lot into the forcasting ability of the stock, bond or commodities markets is a bit risky in this day and age with the amount of manipulation done by the Fed and Treasury. We can't call it just a liquidity dump, since much of it appears visible as excess reserves held at the Fed doing nothing, but then again on my suspicious days I think Lord Blankfien may be instructing his day traders to use the money during market hours, then put it back at the Fed before going home at market close. Then ZIRP rates are supposed to get our animal spirits going and take risk, presumably inflating asset values, in the case where we aren't predisposed to build a factory somewhere and hire a bunch of people.
So I've got another interpretation for recent bond market action. I agree that inflation expectations are on the rise, but I think it is because faith in the Fed executing the "exit strategy" on a timely basis is coming into question, and not really that we are on the way to real robust growth. Kind of like a stagflation lite scenario, but instead of a domestic wage-price spiral driving it, it's import inflation, oil and commodity inflation, and maybe we can even get a wage-price spiral going in China!
So at least we will do our part again to fight world poverty. Who says macroeconomists don't know what they're doing?
Posted by: Cedric Regula at December 26, 2010 04:08 PM
Cedrula Regula wrote:
"Kind of like a stagflation lite scenario, but instead of a domestic wage-price spiral driving it, it's import inflation, oil and commodity inflation, and maybe we can even get a wage-price spiral going in China!"
Yeah except something has to be above its previous peak. Which will it be: import, oil or commodity?
Posted by: Mark A. Sadowski at December 26, 2010 05:01 PM
Cotton wins so far. Up 85% this year. But then we put it on a boat to China, they make it into underwear and ship it back to us. All with diesel up 30% or thereabouts.
Was talking to a guy the other day that buys and sells cows (and steers). He says delivered Argentina beef got more expensive than American cows (and steers). Says his business is booming.
China just announced an interest rate increase on Chistmas day, our time. Some are predicting food riots are just around the corner in China.
Posted by: Cedric Regula at December 26, 2010 05:29 PM
DAILY AVG IN MILLIONS - WSJ
Two weeks ended % CHANGE IN WEEKLY AVERAGES
20.7… -1.4… -4.8
24.6… 3.3… 7.1
30.5… 26.9… 14.2
20.1… -3.1… -5.9
Borrowings from Fed…
-52.8… -70.7… -73.4
24.2… 1.8… 6.6
QE2’s smokin! in the latest 13 week period.
Posted by: flow5 at December 26, 2010 05:35 PM
It's too bad commodities aren't an important percentage of the price of goods in the United States anymore. Otherwise your predictions would be correct.
Posted by: Mark A. Sadowski at December 26, 2010 05:40 PM
OT, Dr. Hamilton, you might like this post on oil prices next year.
Posted by: aaron at December 26, 2010 05:44 PM
Mark,"It's too bad commodities aren't an important percentage of the price of goods in the United States anymore. Otherwise your predictions would be correct.
True. As far as I can tell, the CPI excludes ALL prices, and we are doomed to have zero inflation forever.
Posted by: Cedric Regula at December 26, 2010 06:15 PM
It's too bad commodities aren't an important percentage of the price of goods in the United States anymore.
Yeah; too bad...
Posted by: Babinich at December 26, 2010 06:29 PM
Historically, the yield curve flattens at much lower nominal yields (and periodically negative real yields) during debt-deflationary Long Wave Trough regimes, which we are in today, as in the 1770s-80s, 1830s-40s, 1930s-40s, and Japan since the '90s.
The yield curve does not invert ahead of recessions and bear markets during debt-deflationary regimes; therefore, most e-CON-omists and Wall St. analysts will be fooled (even more so than they typically are) if they wait for the yield curve to invert to persuade them of the increased risk of a recession and bear market; it won't happen.
The flattening yield curve at multi-decade low or negative real yields with bank charge-offs and delinquencies at 10% of bank loans (much higher if bad assets were marked to market) puts an additional squeeze on banks' net interest margin, discouraging banks from expanding their loan books. Banks are charging off 2-3% of loans with delinquencies of 7% of loans (total of $730 billion in charge-offs and delinquencies) while receiving a net margin of 3-3.5%.
Banks can lend to the gov't at a riskless (until it isn't) 2-3.4% for 5-10 years, as well as sell their above-par paper to the Fed for a profit. Why would the banks grow lending under such conditions? Answer: they won't.
The only loan segment that is growing yoy for banks is consumer revolving credit, which has nearly doubled yoy but has fallen at an annualized rate of 11-14% since May-June and Sept. The growth of revolving credit card debt is likely a result of the ongoing household cash crunch as the growth of private economic activity stalls, and higher oil and gasoline prices reach further into the emptying pockets of the bottom 80% of US households.
The Fed will eventually buy with both hands well out the yield curve, even out to 10-30 years.
Recessions and bear markets during debt-deflationary regimes are caused by recurring domestic and int'l bank and financial system stresses from excessive debt levels, external shocks, and fiscal constraints from falling receipts. During debt-deflationary regimes, gov'ts cannot "stimulate" nominal private growth sufficiently to encourage private investment and consumption that result in a sustained increase in receipts to permit gov't to continue growing spending. Central bank printing and gov't borrowing and spending just encourages commodities hoarding and liquidity substitutes, pushing the multiplier and velocity down further.
The only ultimate solution is debt default, pay down, or some combination to reduce public and private debt to wages and production to permit establishing a lower level of private economic activity and much lower public debt/GDP. Virtually nothing that is being done by gov't and the Fed will achieve what is required. Commodities hoarding and Peak Oil are combining to ensure that the price of oil and distillates will preclude real private US economic growth indefinitely.
In the event anyone is interested, the Coppock Curves for many indices around the world are signaling the increasing probability of the onset of a bear market in early '11, with Shanghai, the Nikkei, and the Bovespa perhaps already beginning to discount a bear market and another deflationary global downturn in '11.
Posted by: Nemesis at December 26, 2010 07:06 PM
Did you actually read the article you posted?
A summary might read:
"This just in. Despite the fact total commodity costs rose by (hold on to your seats folks) 2-3% over past year restaurants decide to pass little to none of the price increase to consumers due to the fact that it's a small share of the restuarant industry's total costs (labor alone is over 50%) and that there's a soft economy (not to mention the fact commodities are still cheaper than they were three years ago)."
Posted by: Mark A. Sadowski at December 26, 2010 09:40 PM
Comparatively not dreary at all.
Is the yield curve an impartial witness,when the markets are trending towards monopoly?
GDP prices deflators from 1980 2010
France 47.576 123.82
Germany 63.124 111.28
Switzerland 61.444 109.447
UK 36.638 121.126
USA 54.043 125.598
Zimbabwe 1.549 32,789,388.468 (not applicable after 2008)
Posted by: ppcm at December 26, 2010 11:37 PM
It's too bad commodities aren't an important percentage of the price of goods in the United States anymore. Otherwise your predictions would be correct.
Mark and Cedric,
The comment above has it backward. Commodities do not affect the percentages of the price of goods. Commodities reflect the value of the currency. Rather than driving prices commodities are the canary in the mine, they reflect monetary conditions that drive prices.
Posted by: Ricardo at December 27, 2010 07:15 AM
Your seekingalpha post was good because it almost got the theory right. Oil prices are actually not being driven by supply and demand but by monetary value. As long as the dollar continues to decline the price of oil will continue to rise.
What we are seeing right now is guarded optimism in the markets. With tax increases in 2011 much lower than they appeared they would be just 3 months ago some hope has returned to the productive economy that government confiscation will not be as bad as anticipated.
But we are on hold right now in our economy. Producers are still skeptical about the new government that will begin in January 2011. It is pretty clear that few of the bad decisions that have created our crisis will be reversed since the Democrats have control of the Senate and the veto pen of the president. The question to be answered is has so much damage been done that gridlock will not help with recovery as it did in the Clinton administration?
It appears that 2011 is not longer the disaster it appeared to be just a few months ago but it is far from friendly.
So back to oil, my expectation is that QEII will serve its purpose as cover for the FED allowing them to claim that they stopped the decline, but the FED will do little to actually implement it and that will be good for the currency and good for oil. I expect gold to slow in its price increases and so the price of oil will moderate in 2011.
2011 will be a ho-hum year, but thankfully that is a huge improvement over what the government has done to us for the past 6 years.
Posted by: Ricardo at December 27, 2010 07:29 AM
Another simple reading of the figures is: this isn't much of anything. It may be just the economy improving a little. It may reflect the Fed's actions helping thwart continued disinflation. But it may mean nothing much at all because the shift is small and, as you note, the curve is still below last year. We can read too much into this.
Posted by: jonathan at December 27, 2010 09:05 AM
"One goal of the Fed's second round of quantitative easing begun at the start of November was to flatten the yield curve. That obviously didn't happen, and I discussed some of the reasons why a few weeks ago. A second goal was to increase inflationary expectations, which was achieved."
I just see it as the fed trying to raise the cost of living for most people.
Posted by: Get Rid of the Fed at December 27, 2010 10:06 AM
"The comment above has it backward. Commodities do not affect the percentages of the price of goods. Commodities reflect the value of the currency. Rather than driving prices commodities are the canary in the mine, they reflect monetary conditions that drive prices."
I could not agree more. But using Mishkin's fine Money, Banking and Finance text as my reference I would add the following as advance indicators of monetary policy stance:
1. real interest rates
2. the exchange rate
3. industrial production
4. housing prices in formerly stable markets
5. stock prices
6. TIPS spreads
The important thing is to not get focused on any one single indicator. Fortunately, in my opinion, they were (and are) all saying the same thing.
The PPI commodity price index fell from 205.5 in July 2008 to 168.1 in March 2009, a decline of 18.2%. As of last month it stood at 188.0. In the 97 year history of the index there are only six longer periods where it failed to set a new record. More importantly that was the largest percent decline in commodity prices with the exception of the post WW I period and the Great Depression.
For the past few years, private indicies (take your pick, CRB, CMCI, GSCI, RICI, etc.) have all shown the same pattern of sharp decline and partial rebound with differing levels of volatility based on their composition. So the issue is not public versus private. The issue is the time frame (and/or one's refusal to acknowledge it).
Posted by: Mark A. Sadowski at December 27, 2010 10:37 AM
Babinich, Did you actually read the article you posted?
A summary might read:
Maybe get your head out of an econ textbook and into a menu. Maybe a little time working in the industry would do you a world of good.
A quote from the article: We're obviously in a very cost-sensitive industry
You should re-read the article.
Posted by: Babinich at December 27, 2010 07:59 PM
Cost sensitive implies exactly what it does. It is impossible to pass on any increases in costs to the consumer because the demand for restuarant food is very price elastic.
Once upon a time I did work in the industry. Moreover, once upon a time my aunt founded a very good and unique restuarant:
In the twenty odd years she owned it, it never made much money. But she did make plenty of money off of the Slavic fine arts and crafts she sold there.
If you think you're going to get rich in the restuarant business you better come up with a another scheme.
Posted by: Mark A. Sadowski at December 27, 2010 09:15 PM
Long-term interest rates are determined not only by the various supply and demand factors that affect short-term rates but also by a unique factor; namely, inflation expectations. The expectation that price levels will chronically increase injects an “inflation premium” into long-term rates. The tendency of short-term rates to rise concomitantly with long-term rates is largely the consequence of the substantial substitutability of both short & long-term financing.
Rising inflation expectations operate on both sides of the supply-demand equation. Long-term lenders will demand, in terms of group behavior, interest rate that at least exceeds the “inflation premium”. Thus the higher the expected rate of inflation, the higher the long-term rates. Conversely, borrowers expecting to be able to pay off loans with depreciated dollars will increase their demand for loan-funds. Of the two effects, the supply side is the more important, since it literally establishes the minimum for long-term rates.
The rate-of-change in long-term money flows (the proxy for inflation) is still in a “free-fall”. Until these colossal money flows finally reverse, housing prices will finish declining. Thus, until the slope flattens, longer term maturities will continue to rally from these levels.
Posted by: flow5 at December 28, 2010 07:45 AM
2010 jan ;;;;; 0.22 ;;;;; 0.54
;;;;; feb ;;;;; 0.08 ;;;;; 0.52
;;;;; mar ;;;;; 0.07 ;;;;; 0.53
;;;;; apr ;;;;; 0.13 ;;;;; 0.54
;;;;; may ;;;;; 0.05 ;;;;; 0.53
;;;;; jun ;;;;; 0.03 ;;;;; 0.50
;;;;; jul ;;;;; 0.07 ;;;;; 0.48
;;;;; aug ;;;;; 0.07 ;;;;; 0.49
;;;;; sep ;;;;; 0.06 ;;;;; 0.51
;;;;; oct ;;;;; 0.03 ;;;;; 0.47
;;;;; nov ;;;;; 0.00 ;;;;; 0.42
;;;;; dec ;;;;; 0.11 ;;;;; 0.34
2011 jan ;;;;; 0.10 ;;;;; 0.25
;;;;; feb ;;;;; 0.05 ;;;;; 0.22
;;;;; mar ;;;;; 0.06 ;;;;; 0.21
;;;;; apr ;;;;; 0.10 ;;;;; 0.24
1st column; proxy for real-output: (-5) drop from jan > feb; short-term > sell stocks; buy bonds. I.e., by the time these numbers are finalized, the swing should be more pronounced.
I thought bonds were oversold as the proxy for inflation (2nd column), is now "free falling". But short-term money growth is too rapid:
3 month m1 is growing @ 20.5 SA annual rate percent change, & 13 week m1 is growing @ 15.7 SA annual rate percent change (WSJ Federal Reserve Monetary Data table)
DEC 29: SOMA holdings @ 2,149,525,358.4;
Change From Prior Week (-)7,409,306.9
"On August 10, 2010, the Federal Open Market Committee directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities (agency MBS) in longer-term Treasury securities. The most recent H.4.1 data release indicates that outright holdings of domestic securities in the System Open Market Account (SOMA) totaled $2.054 trillion as of August 4, 2010"
SOMA is NOW UP $96b since the start of the first reinvestment of principal & interest announcement (@ 2,054T)
Posted by: flow5 at December 31, 2010 06:25 AM