Top Ten Reasons Why the Yield Curve Will Flatten (Hint: This Is a Different Sort of Recession)

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Includes: TBT, TLT
by: David Goldman

As I told Larry Kudlow on CNBC Monday night, the employment recovery will be poorer than the market appears to expect, for reasons I’ve posted on this site during the past two weeks. The yield curve is at record steepness. I think that’s an overreaction. In fact, the steep yield curve in the present environment is NOT a harbinger of recovery — it’s a brake on recovery because it encourages banks to own Treasuries rather than risky assets (see below). Here are my top ten reasons to expect the yield curve to flatten.

10) The Treasury is shifting issuance to the long end of the curve, and the market is front-running the Treasury in anticipation of higher issuance. This effect is temporary.

9) Employment won’t come back because the unvarying source of employment recovery — small business — is flat on its back. The credit crunch for small business (with bankruptcies up 44% year on year) keeps getting worse (click to enlarge):

FRED Graph

8) The health care bill (as Goldman Sachs observes) will put onerous requirements on the two out of five small businesses that do not presently have a health care plan and thus discourage future hiring;

7) Inflation on a CPI basis will remain muted because an all-in unemployment rate of 22% (including forced part-time and long-term discouraged workers) will keep wages down;

Alternate Unemployment Chart

6) The steep yield curve will encourage banks to simply fund the Treasury deficit rather than add loans or non-Treasury securities to their balance sheets (click to enlarge):

FRED Graph

As the graph makes clear, banks are buying massive quantities of Treasuries but cutting back on other securities as well as commercial and industrial loans. That is quite new: the long-term data don’t reveal a pattern quite like this any time in the past sixty years. But then again, this is an entirely different sort of recession.

5) The savings rate remains too low: for the Boomers to replace the wealth destroyed in the present crisis (including $6 trillion in home equity since 2007) it needs to exceed 10%. It’s only at 5% at present.

Personal Saving RateClick to enlarge

4) The Fed’s trillion-dollar infusion of credit into the economy (mainly through the purchase of mortgage-backed securities) will level off, suppressing the tax- and balance-sheet-driven uptick in the housing market (click to enlarge):

Reserve Bank Credit - Securities Held OutrightClick to enlarge

3) Continuing credit problems in Europe will weigh on global recovery;

2) Asia’s economic growth simply isn’t of sufficient scale to drag the US out of the recession;

1) And the top reason for the yield curve to flatten is: banks are swimming in money and have nowhere to put it except into the Treasury curve. Securitization of assets is a fraction of previous levels, business loans are shrinking, and the world economy simply can’t create assets at a rate to match bank requirements. But governments are creating assets–and that’s what the banks will buy.