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Wednesday, May 13, 2009


thoughts on the yield curve

bloomberg's caroline baum yesterday penned a good column on the yield curve, a topic near and dear to me from the "interwar" period of 2004-2007. it looked like a bold recession predictor to me as housing really began to deteriorate -- though it came with a massive lead time -- and baum apparently thought as much as well. her comments on the curve now:

The steepening yield curve is not going to nip the recovery in the bud. (These warnings are sure to follow.) To the contrary, it’s a sign that things are improving.

The yield curve was almost vertical in the early 1990s, another period where bank balance sheets were impaired. It took a steep curve for a long time to heal the banks, which borrow short and lend long when they aren’t getting into trouble with newfangled products.

If the Fed wants to worry about something, it should forget long-term interest rates. They will take care of themselves.

Policy makers have much bigger concerns, namely the ability, and political wherewithal, to shrink the Fed’s $2 trillion balance sheet when the time comes.

And when will that be? The yield curve will provide valuable input, assuming anyone is listening.

this interesting quote was included in baum's article.

“If you think monetary policy matters, you should care about the spread,” says Jim Glassman, senior economist at JPMorgan Chase & Co. With the Fed’s “ability to anchor short- term rates at artificial levels, the spread is a way of looking at the stance of monetary policy.”

that's likley to be a proper framing, and the open question is really whether monetary policy is effective in what is shaping up to be a balance sheet recession. if loan demand is broken, does the yield curve matter?

to be sure, baum warns outright against people explaining why "things are different this time" and this isn't a "green shoot". it is a green shoot. but...

revisiting these old yield curve posts is interesting for me for lots of reasons, and not only to verify yet again how wrong i can be at times. in advance of the recession that began in late 2007 i watched a combination of the yield curve, the consumer confidence differential between future expectations and present situation, and the ECRI leading indicators. the curve and confidence metrics triggered very early -- with the curve initially inverting in december 2005 (more definitively in february 2006) and the confidence differential blowing through (-20) in march 2005 on its way to (-50) in march 2007, they're clearly more table settings than timing signals. (though they were among the best motivators for my wife and i to sell our house and start renting.) ECRI (which now maintains a recession watch page) didn't see their weekly leading index go negative growth until september 2007. the peak in the S&P 500 subsequently came in october and recession was eventually antedated to december.

can it all work in reverse? maybe. the confidence differential has turned into a positive indication. the yield curve is now steep by historical standards (400 bps separate the ten-year and the t-bill). but these two indications also led the onset of recession by 18 months or more -- table setting and all that. meanwhile, ECRI's leading indicator (pictured here in green) is still deep in the negative at (-16.1), though less so than it was in november.

it's worth reiterating that, in past cycles, ECRI's WLI growth has tended to go positive before the economy and quite early in the subsequent bull market move in stocks. in the last recession, WLI went significantly (+3.0 or more) positive in january 2002, double-dipped in late 2002 and started up for good in may 2003. it did likewise following negative spells in april 1999, april 1991, october 1988, february 1985, november 1982, november 1980, june 1975 and january 1971. there are worse buy points than these.

stockcharts' dynamic yield curve is, as always, here.

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