Wednesday, November 15, 2017

The yield curve is not a red flag

In the past week or so I've see more and more people worrying about the flattening of the Treasury yield curve. I've also seen breathless stories about how the nation's malls are emptying, subprime auto loan defaults are surging, and student loans are defaulting. While these are all disturbing developments, a lot of other things will need to happen before the economy is at risk of falling into another recession. In that regard, I note that credit spreads are still relatively low, swap spreads are very low, real yields are very low, inflation and inflation expectations are right where they should be, and the financial system has tons of liquidity.

The following charts put some meat on my argument, and all contain the most up-to-date data available as of today.

Chart #1

The first chart sums it all up: it's Bloomberg's index of all the factors that contribute to financial market conditions. By this measure, financial conditions are about as good as they get. The following charts drill down into these factors to see how they stack up and what they mean.

Chart #2

The chart above is one of my favorites. It shows that two things have preceded every recession since 1960: real interest rates (blue line) have risen sharply, and the Treasury yield curve has gone flat or inverted (red line). That's another way of saying that the Fed has been the proximate cause of every recession in modern times. They have tightened monetary policy to such an extent that the economy just couldn't take it anymore. Until 2008, when Quantitative Easing started, the Fed tightened policy by withdrawing bank reserves from the financial system. Banks need reserves to back up their deposits, so when reserves become scarce they must pay more to get the reserves they need: this pushes up short-term interest rates. It also results in a general scarcity or shortage of liquidity. Rising rates and tighter liquidity conditions start eroding the economy's underpinnings. The economic and financial fundamentals deteriorate until people are forced to sell and panic ensues.

Chart #3

This time around, however, things are VERY different. Because of Quantitative Easing, the Fed can't tighten like they used to. They can't even begin to make bank reserves scarce enough to forces short-term rates higher. As Chart #3 shows, there are about $2 trillion of excess reserves in the system: way more than banks need to back up their deposits. The Fed gets around this by paying interest on reserves, which it never did before. In the old days banks always wanted to minimize their reserve holdings because they paid no interest. Nowadays banks don't worry so much, because reserves pay interest that is close to what T-bills pay; reserves are an asset today, whereas they were a deadweight loss before. By increasing the rate it pays on reserves, the Fed directly impacts all short-term interest rates without there being any shortage of liquidty.

So this tightening cycle that we are now in will be very different from past tightening cycles, because it will be a long time (years) before the banking system approaches the point at which bank reserves become scarce—the Fed is going to unwinding its balance very slowly. The Fed can "tighten" by raising short-term interest rates, but they can't create a shortage of liquidity like they did before. So it's not surprising that despite higher short-term interest rates and a flattening of the yield curve, there is as yet no sign that financial market conditions are deteriorating, as the following charts demonstrate.

Chart #4

Chart #4 shows the 40-year history of the Treasury yield curve. The bottom two lines show the yields on 2- and 10-yr Treasuries, while the top line (blue) shows the difference between the two (i.e., the slope of the yield curve). Here we see that flatter and inverted curves are always the result of short-term interest rates rising by more than long-term interest rates. That's the Fed in action. We also see that the yield curve can be fairly flat, as it is today, for many years before a recession hits (e.g., the mid-90s). To really squeeze the economy, you need not only a flat curve but much higher interest rates and a shortage of liquidity.

Chart #5

Chart #5 shows the real yield curve in action. Real yields are the true measure of how high or low interest rates are. A 10% yield in a 10% inflation environment is not a big deal, but a 10% yield in a 2% inflation environment is a killer. The blue line is the Fed's real short-term interest rate target. Currently it is about zero, or it will be next month, when the Fed will almost surely announce that the rate it pays on reserves will rise to 1.5%. That's just a tiny bit less than the underlying rate of inflation (1.6%), according to the PCE core deflator, which is the Fed's preferred measure of inflation. (PCE Core inflation is typically about 30 to 40 bps less than CPI inflation.)

As the chart also shows, the front end of the real yield curve is pretty flat. What that means is that the market doesn't expect the Fed to tighten much more after the December meeting. The 5-yr real yield on TIPS is effectively the markets' expectation for what the real Fed funds rate will average over the next 5 years. Note that prior to the last two recessions the real yield curve inverted: the blue line rose above the red line. That meant that the market expected the Fed to start lowering interest rates in the foreseeable future, because the market sensed that monetary conditions were beginning to undermine the economy's fundamentals. That's not the case today.

Chart #6

2-yr swap spreads are among my most favorite indicators, because they have been good leading indicators of economic conditions. In normal times, swap spreads are 10-30 basis points. Today they are 18 bps. Just about perfect. That means that liquidity is abundant and systemic risk is low. The financial markets are not worried at all about widespread defaults or a liquidity squeeze. The Fed hasn't tightened at all, by this measure.

Chart #7 

Chart #8

As charts 7 and 8 show, credit spreads are fairly low. Despite the news of defaults in certain sectors of the economy, investors by and large are not worried much about widespread defaults. This also tells us that the Fed hasn't really tightened at all. Corporations can borrow as much as they want without having to pay onerous interest rates.

Chart #9

Finally, Chart #9 shows that the market's expectation for consumer price inflation over the next 5 years is 1.85%, just a bit shy of the Fed's professed target of 2%. That's plenty good enough for government work, as they say. The Fed has delivered 2% CPI inflation (annualized) for the past 20 years, and the market fully expects more of the same. Nobody is worried that the Fed is going to have to tighten unexpectedly.

Until we see the yield curve actually invert, until we see real yields move substantially higher, until we see swap and credit spreads moving significantly higher, and until inflation expectations move significantly higher, a recession is very unlikely for the foreseeable future.

UPDATE: I'm adding my oft-used chart that shows the "Obama Gap," which illustrates how dismal the economy's rate of growth has been over the past 8 years, compared to what it was for the previous 40+ years. You'll find some discussion of this subject in the comments section if you're interested.


Benjamin Cole said...

Yet another excellent post by Scott Grannis.

Also. the International Energy Agency just predicted that US oil-and-gas production should rise by another 25% by 2025.

I never liked the Peak Oil crowd, and I never attributed a lot of inflation to energy prices. OIl is important, but not the crux of all matters.

Still, the excellent news of the past decade has been the US shale oil-gas story, and the globalization of energy efficiency.

My guess is oil will be abundant for decades forward---and that is before an Iran, Iraq, Venezuela, or Mexico gets their act together. We may see gluts again.

We also may see battery cars with 400-mile range soon. Many nations are moving forward to ban new ICE car sales, and one has to wonder if there is a right to pollute the air other people breathe.

The Fed faces one serious bottleneck--housing. What is causing inflation in the US is not labor, but scarce housing, due to property zoning.

The Fed can do nothing about this, but it would be nice if they recognized the problem, as used their bully pulpit, so to speak.

Rcession ahead? I do not think so, but then every recession seems to be a surprise.

Fore Craft said...

This blog is great, been following since Summer 2017.

I am also more of a Flat Oil guy, although I do think WTI Crude might break above $60 or even test $75 due to high GDP expectations in US and EU. But the Business Cycle is already very strong with PMI at 60 and Europe ESI above 110... Are we at the top of this cycle yet?

If we are, then WTI Crude might have already priced in the highest expectation of future demand, and would have already hit it's "top" at $57? China's Business Cycle, which I think lags EU+US, might start accelerating and drive energy demand outlook higher.

I'm not too sure what to make of all this, since GDP outlook and market participants are Bullish on Crude, and for good reasons. Yet future Supply remains an issue, as well as rise of alternative energy sources (ie more Nat Gas/LNG). Plus Saudi looking to "diversify" away from Oil with ARAMCO IPO? How much longer can OPEC maintain production cuts?

I definitely feel like the Market is finding excuses to bid up WTI prices, and I don't like to disagree with the beast. But wow the fundamentals and future outlook is very conflicting to me!

Wonder what Scott Granis' opinion is on the demand side of oil...!

Flying Robot said...

Great post! I really enjoyed the view across several aspects of the credit market. Of course, everyone loves it when their own view of the world is confirmed, but as much as I look for weakness in the bull market, it's tough to find significant warning signs let alone real concerns. Well, outside North Korea and the threat of nuclear exchanges, but to me that likelihood seems low. Thanks for the insight!

Alain said...

I like the credit spreads post. Always keep the big picture in perspective.

Benjamin Cole said...

Numbered charts! Hooray!

Benjamin Cole said...

Interesting question: should the Fed keep its balance sheet? Scott Grannis hints at some positives...

Scott Grannis said...

Benjamin: the numbered charts are there because of you. You had a good idea that took me too long to adopt.

The jury is still out on the balance sheet question. If the Fed needs to tighten meaningfully and raising the interest it pays on reserves doesn't do the trick (although so far it seems to be working just fine), then having a ton of excess reserves in the banking system could lead to frightening consequences.

I've maintained all along that QE was not about printing money, it was about transmogrifying notes and bonds into T-bill equivalents. That was necessary to satisfy the world's huge demand for safe assets. So if the demand for safe assets declines, the Fed would do well to shrink its balance sheet. It can always grow it again if need be.

xr-3609 said...

Excellent post! The premise is made, the data given by way of the chart, and then the data explained by way of the text! There are a lot of financial opinions on the net, if you can find ones that are as well articulated as the ones you find on this blog; it is a beyond a three standard deviation event. Numbered charts are also nice!

Scott Grannis said...

xr: thanks, glad you appreciate it!

Matthew Grech said...

I love these posts, the ones that give a multi-chart, broad view of where we stand. Thanks, Scott.

Question: Under what scenario would "raising the interest it pays on reserves" not do the trick (draining liquidity)? I've maintained since the Fed adopted this program that it gave the Fed a hammer lock on the money supply, certainly far more than they'd had previously. This is because the Fed can now directly affect the entire bank lending function, and almost immediately. Am I missing something?

Scott Grannis said...

Matthew: First, as I said above, IOER appears to be working just fine; the Fed has demonstrated the ability to effectively lift all short-term interest rates to its target without having to drain reserves (and without having to restrict liquidity). What remains to be seen is whether it is possible to "tighten" monetary policy without also restricting the supply of liquidity—can higher short-term rates by themselves keep the supply of and the demand for money in balance when the demand for money is declining? Logic seems to say yes, but we haven't really put the new scheme to the test; we're still in the early innings. I'm optimistic, but watching things carefully: how is the curve responding, how are swap spreads behaving, how are credit spreads behaving, etc.