"I Got Into College. This Is Terrible!"
When I was a snarky 18-year old, this was one of the jokes that my friends and I found extremely funny. Of course, at 18, we were obsessed with getting into a good college. I never knew why, but throughout the whole process, the suicide rates at particular colleges seemed to come up all the time. A friend might say to a random person, "I've applied to Cornell," which would prompt the response, "You know they have the highest student suicide rate, don't you?" So my friends and I relished the absurdity of the notion that if one attended a 'high-suicide' college, one was bound to feel increased suicidal urges.
This is what I am reminded of at the inverting of the yield curve. The only formulation that media can really come up with when talking about this phenomenon is that the inverted yield curve means recession. Typically, it is "an inverted yield curve presages a recession" or "an inverted yield curve has presaged the last five recessions." More circumspect media treatments might tell you that recessions generally follow the inversion of the yield curve but not always, but even this description is thin on the ground in the mainstream media. If you otherwise didn't know much about the yield curve beyond what you read in the MSM, you could be forgiven for thinking that an inverted yield curve causes recessions. So let me get a basic truth out there as a starting point: the inversion of the yield curve does not cause a recession. The slope of the yield curve is an effect, not a cause. The yield curve reflects supply and demand and you have to look deeper to see what is driving the curve's slope.
Typically the yield curve inverts when the Fed is driving up short term rates to fight inflation and there is something in the supply/demand balance for longer term money that keeps the long end stable or even allows it to fall. If that something were, say, corporate and/or consumer reluctance to invest, and thus borrow, keeping long corporate rates down, then a recession would be the likely result and this is typical of how events have played out in the past. However, while the Fed has been driving up short rates since June of 2004, it is worth noting that the inflation expectations of the marketplace have not been in tune with the Fed. An overwhelming sense of inflation-dovishness has persisted, which has worked to keep the yield curve flat. If inflation fears were severe and widespread, investors would be demanding more yield at the long end of the curve and existing portfolios would be rejiggered to the short end to mitigate reinvestment risk and capital loss, which would be a steepening influence upon the curve. This has not been the case as the pervailing sentiment in 2005 was that the Fed would raise a handful of times and stop. As this view was losing ground slowly throughout the year, hurricanes Katrina and Rita gave it a second life (see here). I think that this is a major, but just one, factor driving the supply/demand of the long end. Greenspan himself has fingered a worldwide glut in savings, partly attributable to fantastic petro profits around the world. Petro states don't reinvest their money locally, because generally the local economies stink (do you think there are great investment opportunities outside of the energy sectors in Venezuela, Russia, Saudi, and Iran?). You can also finger the Chinese and Japanese who desperately need to maintain high exports to us, China to create jobs to keep social unrest at bay and Japan to keep their incipient recovery from miscarrying, but don't necessarily have fine choices on what to do with all those dollars. Corporations have slowed their borrowing but not because they are refusing to invest in future growth, rather because more of the capital expenditure budget is coming from rising profits and free cash thrown off in recent years by refinancing lower. Balance sheets were retooled the last few years and current cash flow is funding investments - the animal spirits are not sickly.
So it is probably alot of things that are conspiring to keep the long end from moving upward, but none of it seems to presage bad things. Foreign investment is flowing into the US and corporate investment remains robust.
Another thing to think about is the level at which today's inversion is taking place. I don't have data handy on what level the past inversions took place, but I suspect they have been at higher levels than today's 4.3%. The effect of rate shifting at 6+% is alot different than at 4%. I think the economy will react differently to rates rising from 1% to 5% than it would if rates were rising from 4% to 8% or worse, so 2005/06 will not prove analogous to past periods of rising rates and inverted yield curves.
We are not destined for recession any more than I or my friends were destined to commit suicide by going to certain colleges.
This is what I am reminded of at the inverting of the yield curve. The only formulation that media can really come up with when talking about this phenomenon is that the inverted yield curve means recession. Typically, it is "an inverted yield curve presages a recession" or "an inverted yield curve has presaged the last five recessions." More circumspect media treatments might tell you that recessions generally follow the inversion of the yield curve but not always, but even this description is thin on the ground in the mainstream media. If you otherwise didn't know much about the yield curve beyond what you read in the MSM, you could be forgiven for thinking that an inverted yield curve causes recessions. So let me get a basic truth out there as a starting point: the inversion of the yield curve does not cause a recession. The slope of the yield curve is an effect, not a cause. The yield curve reflects supply and demand and you have to look deeper to see what is driving the curve's slope.
Typically the yield curve inverts when the Fed is driving up short term rates to fight inflation and there is something in the supply/demand balance for longer term money that keeps the long end stable or even allows it to fall. If that something were, say, corporate and/or consumer reluctance to invest, and thus borrow, keeping long corporate rates down, then a recession would be the likely result and this is typical of how events have played out in the past. However, while the Fed has been driving up short rates since June of 2004, it is worth noting that the inflation expectations of the marketplace have not been in tune with the Fed. An overwhelming sense of inflation-dovishness has persisted, which has worked to keep the yield curve flat. If inflation fears were severe and widespread, investors would be demanding more yield at the long end of the curve and existing portfolios would be rejiggered to the short end to mitigate reinvestment risk and capital loss, which would be a steepening influence upon the curve. This has not been the case as the pervailing sentiment in 2005 was that the Fed would raise a handful of times and stop. As this view was losing ground slowly throughout the year, hurricanes Katrina and Rita gave it a second life (see here). I think that this is a major, but just one, factor driving the supply/demand of the long end. Greenspan himself has fingered a worldwide glut in savings, partly attributable to fantastic petro profits around the world. Petro states don't reinvest their money locally, because generally the local economies stink (do you think there are great investment opportunities outside of the energy sectors in Venezuela, Russia, Saudi, and Iran?). You can also finger the Chinese and Japanese who desperately need to maintain high exports to us, China to create jobs to keep social unrest at bay and Japan to keep their incipient recovery from miscarrying, but don't necessarily have fine choices on what to do with all those dollars. Corporations have slowed their borrowing but not because they are refusing to invest in future growth, rather because more of the capital expenditure budget is coming from rising profits and free cash thrown off in recent years by refinancing lower. Balance sheets were retooled the last few years and current cash flow is funding investments - the animal spirits are not sickly.
So it is probably alot of things that are conspiring to keep the long end from moving upward, but none of it seems to presage bad things. Foreign investment is flowing into the US and corporate investment remains robust.
Another thing to think about is the level at which today's inversion is taking place. I don't have data handy on what level the past inversions took place, but I suspect they have been at higher levels than today's 4.3%. The effect of rate shifting at 6+% is alot different than at 4%. I think the economy will react differently to rates rising from 1% to 5% than it would if rates were rising from 4% to 8% or worse, so 2005/06 will not prove analogous to past periods of rising rates and inverted yield curves.
We are not destined for recession any more than I or my friends were destined to commit suicide by going to certain colleges.
posted by Donny Baseball at 11:31 AM
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