Lately, we’ve been discussing the Yield Curve, its flattening and inversion and how its different this time (not). This has been termed a "conundrum" by outgoing Fed Chair Alan Greespan.
Many commentators have cited foreign buying of longer-term treasuries as the reason for this "conundrum."
While the U.S. yield curve has flattened considerably since its August
2003 peak,that period hardly marks the beginning of foreign purchases
of US Treasuries.
Further, if we take a fresh look at curves elsewhere, we see this issue is not limited to the U.S. As the chart below reveals, Yield curves around the globe are flattening.
While numerous rationales try to explain away the US inversion as an anomaly, the excuse making ignores the small fact that the US is not the only country with a flattening Yield Curve: So too are Japan, UK, Germany, Switzerland, Canada and Australia.
The yield curve inversion naysayers have yet to explain how foreign purchases of U.S. Treasuries are flattening curves elsewhere also.
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click for larger graph
Source: Mike Panzner, Rabo Securities
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Funny, those who try to convince you the Yield Curve doesn’t mean anything aren’t mentioning this inconvenient factoid of Global Curve Flattening.
To paraphrase Panzner: "Given that spreads between long and short-term rates in many major bond markets (including Japan) have also fallen recently, perhaps "this time" is not so different after all? Could it be that global bond markets are anticipating an impending slowdown?"
Here’s a typical set of explanations:
1) stock-market investors fled the crash of 2001, and their alternative-investment strategies have soaked up the supply of bonds and other fixed-income securities.
2) China and other Asian countries are parking their dollars to drive up the value of the U.S. currency and keep their export-driven growth booming.
3) U.S., European and Japanese populations are aging, and with age comes an investment preference for security and income.
4) prices for everything except fossil fuels are being held down by productivity increases, international competition and excess manufacturing capacity.
-Peter Morici, international economist at the University of Maryland’s business school
At first blush, these all appear reasonable. However, a closer look reveal the flaws in each of these explanations:
1) This is belied by the enormous amount of cash and cash equivalents — trillions of dollars in money market accounts — hardly equates to "soaking up bond supply;" And, the crash began in 2000;
2) Foreign buying of US bonds cannot explain flattening yield curves elsewhere (See chart above);
3) True dat; Now what about the very young populations in the rest of Asia and the Middle East? Or do we just pretend they are not market participants, and ignore the fact their equity markets have all soared in 2005?
4) Astonishingly misleading statement: Nothing is going up except oil? How about food, building materials, education costs, industrial metals, healthcare, raw goods, insurance, housing, precious metals — they all have risen dramatically.
While most goods have gone up in price, while a handful of items have come dwn. When we talk about electronics, note that the mechanism that brings their proces down is an economy of scale. The first few units are prohibitively expensive, essentially paying for the factories. The next wave are some what cheaper, and by the thrid iteration, they become mass produced and much less expensive. Think Plasma screens: They have all plummeted in price — excepting, of course, for the one screen that I want.
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For the numbers geeks, here are the actual changes in the 10-year vs. 2-year government bond yield spreads for selected countries since August, 2003 (which was the most recent major peak, based on weekly data, in the U.S. spread):
| Country | 8/29/03 Spread % |
Current Spread % |
Difference (Positive Value = Flattening) |
| US | +2.496 | -0.009 | +2.505 |
| Germany | +1.604 | +0.447 | +1.157 |
| Japan | +1.264 | +1.188 | +0.076 |
| Switzerland | +2.186 | +0.506 | +1.680 |
| UK | +0.438 | -0.091 | +0.529 |
| Canada | +1.773 | +0.118 | +1.655 |
| Australia | +0.557 | -0.020 | +0.577 |
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UPDATE 1 JANUARY 6, 2005, 1:31pm
Check out this Sunday’s NYT for more on this phenomena . . .
UPDATE 2 JANUARY 8, 2005, 8:31am
This is in today’s Sunday NYT
The World Isn’t Flat, but Its Yield Curve May Be
Economic View
DANIEL GROSS
NYT, January 8, 2006
http://www.nytimes.com/2006/01/08/business/yourmoney/08view.html>
Sources:
Michael Panzner, Rabo Securities
Scatter Shots
THOMAS G. DONLAN (Editorial Commentary)
Barron’s, MONDAY, JANUARY 2, 2006
http://online.barrons.com/article/SB113598713395735177.html
citing Peter Morici, international economist at the University of Maryland’s business school
From Bob Carver’s daily financial comments to argue against what was said above:
We’ve been discussing the yield curve around here for many moons, but the media apparently just caught on last week and started their usual round of fear-mongering. While it’s true that an inverted yield curve has been the best predictor of recessions — better than all of the Blue Chip Economists individually or as a group — it has not given, nor will it give, a recession signal until, at the earliest, sometime in March 2006. This looks like a setup engineered by the insiders: get their buddies in the media conglomerates to hammer the public with “bad news” and convince them to sell out. Of course, they got it wrong, just as they usually do.
First of all, the “real” yield curve is measured by subtracting the 90-day Treasury Bill interest rate from the 10-year Treasury Note rate. The media hammers away at the difference between the 2-year and 10-year rates instead. That’s one strike against the media: the 90-day rate remains well below the 10-year rate, a normal relationship (not inverted).
Secondly, the forecasting ability of the yield curve for recessions requires the yield curve to be negative (90-day rate above the 10-year rate) for 90 days before a signal is given. That just has not happened yet. So far, the media has two strikes against it.
Finally, even if the true yield curve is negative for 90 days (we won’t know for at least three months, and probably much longer than that), a recession signal from this indicator typically will see the stock market continue to rise for several months thereafter — and a recession usually occurs at least 9 months after the signal is given! Three strikes and you’re out, Media Moguls!
The comment posted seems pretty random. The spread of 10 year to 90 day rates is, indeed, positive. But in the past year it has contracted by 164bp. The 2 year/10 year spread contracted, over the same period, by (only) 112bp. Even if using the 90 day/10 year spread as the “right” spread to look at, I’d say the direction that the spread is moving in is pretty compelling.
And who thinks that one can only draw conclusions if the 90 day/10 year spread is negative and then only for 90 days? That is pretty bizarre and rigid. Maybe the accuracy of predictions based on 2 year/10 year curve movement isn’t as accurate as 90 day/10 year 90 days later, but this is about forecasts not history.
I don’t really care about the word recession or its definition. The economy can be going to hell in hand basket but we can still have positive GDP growth.
In Canada in the beginning of the 90s, we went through the wringer. By the mid 90s GDP growth was positive but the general population still thought we were in the midst of a recession. And this lasted for a few years! By 1994-95, when looking at a listing, a boomer came up to me and told me real estate was the worst investment I could ever make. When we bought, all media articles were telling us that kitchen renos were the worst investment you could make. You couldn’t even recoup the cost of window replacements.
It’s easy to generate GDP growth. Government can spend like a maniac (and print more bonds) and businesses can invest like crazy while laying off employees. You can get economic growth and still have a bad economic environment.
The economy has been doing well because of massive lending. Leverage is what the last few years (the last 20 actually!!!) has been all about. At the end of the day, if it does not make sense to lend, it won’t be done. Banks lend long and borrow short. A flat yield curve kind of screws up that business model.
Unless North America’s general business model does not work on profits anymore, a flat yield curve can not be something good.
Most of the the “foreign” buying of 10-30yr bonds are offshore hedge funds and real money funds playing the
Yen carry trade (short yen long us higher yielding instruments) or the the flattening trade. Foreign central bankers are mostly in the short end to 5yr area, which is the most liquid part of the curve with less
principal risk.
Anybody with any fiduciary responsibility would choose the 2yr over 10yr with the same yield….unless they believe that the 2yr will go lower!!! i.e a slowdown in the us economy.
The reason the mkt (not the media’s choice) looks at the 2/10yr spread it is because it is the most liquid, mkt driven rates (untouched by the fed directly and not influenced by the lack of supply in the very long end.
It could also have something to do with a longer term shift at pension funds away from equities to debt that will better match their obligations. Maybe some of the managers were getting spooked.
Or it could do with petro-$ finding its way into something safe for now while the holders are waiting to get a better sense of where the oil market will go.
Jan 1 Prof DeLong blog:
“This inversion of the yield curve, however, is generated not by domestic investors’ thinking that a recession is on the way, but by foreign central banks’ desires to keep buying lots of dollar-denominated bonds in order to keep their currencies from appreciating.”
Thank you for another great chart.
It confirms that markets have gone global. In the old days, the r squares for various international markets were much lower than they are today. With all the currency swaps and arbitrages available now, it is no surprise that fixed income markets are trading in sync.
The question remains, has the FOMC and other central bankers gotten ahead of the curve or not? The relatively flat curves suggest the markets believe they are close. However, the weighted average of the curves are not nearly as low as levels hit in July and August of 2000; in particular, the German and US curves were well into negative territory at that time. The current levels are not forecasting a dramatic slow down.
Indeed, today, the curve steepened when short rates fell significantly more than long rates. Before the FOMC minutes were released today, one could sense the fear in the market for just how rough it could be if rates keep going higher and higher. This fear is as important as the actual moves in determining the correct ultimate peak in rates. Many a commercial project is on hold as businesses anxiously await the peak.
On the other hand, take a look at the rate of increase in semiconductor capacity utilization and you will see what is feared by the central banks. Production can only go straight up for a short time before inefficiencies creep into markets. I do not want to over-state this point because the productivity in this sector has been incredible. It has been reported that INTC now makes about $500,000 worth of product annually per employee. The sector took such a beating at the end of the bubble that there is still room for growth but I am sure the central bankers would like to see at least a little horizontal slant to this production curve before they take their collective feet off the brakes.
Indian Yield Curve
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Read it here first: The World Isn’t Flat, but Its Yield Curve May Be
Earlier this week, we brought to your attention A World of (mostly) Flattening Yield Curves. In the Sunday NYTimes today, Dan Gross does a nice job on the same subject: But there are signs that the United States no longer has a monopoly on the conundru…
Read it here first: The World Isn’t Flat, but Its Yield Curve May Be
Earlier this week, we brought to your attention A World of (mostly) Flattening Yield Curves. In the Sunday NYTimes today, Dan Gross does a nice job on the same subject: But there are signs that the United States no longer has a monopoly on the conundru…