Yield Curve: Green-Shoot? Weed?

By Dirk van Dijk

The yield curve has recently become extremely steep. While there are many ways to measure the curve, the graph below is based on comparing the 10-year T-note with the one-year bill.

The conventional way to measure the curve is to look at the difference between the long-term and short-term rate. I have always felt that this method, while useful, does not tell the whole story, since it does not reflect the overall level of interest rates. After all, long-term rates were at 10.93% in August of 1980 while short-term rates were 9.71%, for a spread of 1.22%. Almost identical spreads were recorded in January 1991, April of 2001 and March of 2005. However, in 2005, long-term rates were only 4.59%.

I would argue that the yield curve was much flatter in 1980 than in 2005. Therefore I have also included the ratio of long rates to short rates. Keep in mind that for the spread, a flat curve is 0.0, while for the ratio it is 1.0.

On a spread basis, the curve is very steep at 3.10%, but it is not unprecedented. It has been above 3.0% in 2.5% of the weeks since 1962, and above 2.0 in 15.6% of the weeks. It has averaged 0.86% over the period.

However, on a ratio basis we are simply off the charts here. We are now at a ratio of 7.32, while it averages 1.31. Until very recently, the highest the ratio had ever reached before is 3.70 in July 2003.

I don't have recession bars in the graph, but generally a steep yield curve is associated with an improving economy, while an inverted yield curve is one of the absolutely best predictors of an upcoming recession (but often returning to positive slopes before the recession actually hits).

[click to enlarge charts]

Is the steep yield curve a green shoot? Yes, but there may be more than that going on. The Chinese have started to change their portfolio. They have already dumped their agency paper and have been shortening up the duration of their Treasury portfolio.

A steep curve would also be consistent with market fears of potential deflation in the near term followed by higher inflation later. The Fed has been fighting deflation with a vengeance, pumping in unprecedented amounts of liquidity, and resorting to many unconventional means of doing so, with an alphabet soup of liquidity plans (e.g. TALF) and actually engaging in quantitative easing.

They appear to have been successful in their fight so far, but at the cost of a huge increase in the Fed balance sheet and the monetary base as shown below. If indeed "inflation is always and everywhere a monetary phenomenon" as Milton Friedman famously said, then fears of higher inflation down the road are very well founded.



However, in the meantime, a very steep yield curve is a big and underappreciated factor in the bailing out of the banks. After all, the economic function of banks is to borrow short and lend long. Banks like Wells Fargo (WFC) and BB&T (BBT) must be liking the current shape of the curve. However, if it is pointing to higher inflation down the road, this "green shoot" will turn out to be a very nasty weed.

Comments

[Leftfield:]

Can our increasingly gov't/corporate fascist economy in the throes of financial meltdown and threatened loss of reserve currency privileges during epic deficit financing respond to a steepening yield curve as it has since WWII? At some point a hospital patient or drug addict doesn't respond to medication or drugs the same at all.

Jun 04 09:48 AM

[Leftfield:]

Can our increasingly gov't/corporate fascist economy in the throes of financial meltdown and threatened loss of reserve currency privileges during epic deficit financing respond to a steepening yield curve as it has since WWII? At some point a hospital patient or drug addict doesn't respond to medication or drugs the same at all.

Jun 04 09:48 AM

[White Shield:]

"Apples and oranges", my friend. Do not fall into the same trap Laffer has, using old paradigms and economic formulas to "examine" the current situation. There's a new 800 pound gorilla in the room:

bailout.propublica.org...

...and he's about to run out of bananas.

Jun 04 10:30 AM

[CautiousInv...:]

The point that needs to be made is that we cannot be certain of anything; QE and simultaneous and massive fiscal stimulus, accompanied by epic debts, is a new experience for us and represents uncharted waters. Old benchmarks may or may not apply.

Right now we know the bond yield curve is steepening, the currency is weakening, investors are favoring the short over the long end and the Chinese are worried sick about our financial house. The markets are telegraphing a message through longer-term higher interest rates which says something the market’s appetite to hold longer dated maturities. These are what we shall call as knowns.

Opinions about output gaps, inflation/deflation, potential crowding out, how much we need to borrow, risk preferences, mortgage hedging and how quickly the Fed can unwind its balance sheet in the face of inflation are essentially unknowns. And the opinions vary and are subject to political leanings.

Amidst this uncertainty, clever arguments can be made most things, including that we can borrow almost indefinitely but markets understand we are approaching the point where there will be insufficient demand to absorb the supply of borrowing. At this point debt must be monetized.

This would lead to spiraling inflation which could only be stopped by inflicting great pain. We have taken too many risks lately all based upon perfected outcomes; the market is simply saying there is too risk in unrestrained borrowing, including a potential collapse in the dollar and loss of its status as a reserve currency.

There are options to take the risk off the table and return to a world of knowns.

Jun 04 11:00 AM

[Larrysyr:]

On a ratio basis, the yield curve would have to be off the charts because the short end has never been nearly this low. The problem is that banks operate on the absolute spread because this is how they cover their (mostly) fixed operating expenses. The AMOUNT generated by loans has to be enough above the AMOUNT paid to depositors and investors to generate income.

It is very difficult in low-interest-rate environments to generate enough spread to make banking profitable. Furthermore, fixed-rate loans initiated at low-interest rates add risk to bank finances. That's one of the reasons banks resort to fees and non-banking activities to shore up their profits.

There are certainly other factors at play today, but the yield ratio remains less meaningful than the actual spread.

Jun 04 11:27 AM

[Heaven, Hel...:]

>> However, in the meantime, a very steep yield curve is a big and underappreciated factor in the bailing out of the banks. After all, the economic function of banks is to borrow short and lend long. Banks like Wells Fargo (WFC) and BB&T (BBT) must be liking the current shape of the curve. <<

Very good and often overlooked point when talking about the steepeness in the yield curve these days. But of course, banks must actually lend in order to take advantage of the spread and as we have seen, on an aggregate basis lending has declined in banks which have received TARP banks.

Jun 04 12:19 PM

[Kinabalu:]

"the economic function of banks is to borrow short and lend long"

Actually that's not correct. Banks spend a lot of effort to match their asset/liability exposures. You will rarely find one that has a significant percentage of loans beyond 3-5 years. The best example of that is the securitization of long term mortgages. They sell them not only to get cash for further lending, or to capture a spread, but also to get rid of the long term funding risk.

Jun 04 08:07 PM

[dcb:]

amazing, three thumbs down for actually telling the truth.


On Jun 04 09:48 AM Leftfield wrote:

> Can our increasingly gov't/corporate fascist economy in the throes
> of financial meltdown and threatened loss of reserve currency privileges
> during epic deficit financing respond to a steepening yield curve
> as it has since WWII? At some point a hospital patient or drug addict
> doesn't respond to medication or drugs the same at all.

Jun 05 04:43 AM

[dcb:]

interesting link to tech ticker. note on the graph where the bull market on stocks takes off. also how amnt of debt corralates (sp) to the stock market itself. the point is that we have a market that is not based on asset values, but falsely elevated by credit and that credit (debt) must be destroyed and worked down.

Jun 05 04:50 AM

[dcb:]

sorry:
finance.yahoo.com/tech...

Jun 05 04:50 AM

[christophe:]

interesting articles....thank you.

One could argue that the only way out is a dose of inflation.

Generally countries behave like the aggregate of its people. I call this the law of "micro-macro". This law goes along the lines that, if enough individuals in a country behave a certain way or have a certain characteristic, you can find that behavior/characteristic in the countries behavior....

Our economy is in difficulty due to the millions of people virtually going bankrupt because their biggest asset is upside-down. This "characteristic" is now found at the country level: the country was virtually bankrupt. The advantage of the US, is to be the leading economy and political force, so we can avoid bankruptcy and solve our problem by generating inflation (printing money).

The end result is to return that $500,000 home (2007 home value) to a similar level to avoid the dominos effect of the ever shrinking asset values. For example, your neighbor's home goes from $500k to $250k at a foreclosure sale, so your other neighbor with a $400k loan is now upside-down and has to foreclose, selling his home for $200k. This in turn, puts you in difficulty with your $300k loan, so you have to foreclose and sell your home for $150k etc..... This out of control spiral has to be stopped. There is only 2 ways to stop this cycle, go bankrupt (not an option for the US at this point) or virtually adjust asset prices by generating inflation (what we are probably doing at this point).

Jun 05 06:33 AM

[Larrysyr:]

I suspect that the negative response is to the word "fascist." This word (and others like "socialism") cut off the conversation because they invoke images of evil without explanation, and do not actually have very clear meanings.


On Jun 05 04:43 AM dcb wrote:

> amazing, three thumbs down for actually telling the truth.

Jun 05 10:59 AM