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Tuesday, November 09, 2010


the steep yield curve of the 1930s

richard shaw seeking alpha ran an article back in 2007 with a providential chart of the yield curve spread dating back to 1927.

what's worth noting is that the curve steepened throughout the deleveraging of the early 1930s with absolutely no inflationary implication, and stayed steep through the second world war. this feeds directly into the rationale of removing the yield curve from leading economic indicators during deleveraging cycles.

a steep curve is normally indicative of a large spread to be harvested by banks if they have the wherewithal to lend. lending growth drives growth in financial assets, income and aggregate demand, and can indeed foment inflation if such growth outpaces capacity. as such, it has a rightful place among leading economic indicators under normal circumstances.

but "normal circumstances" is very far from where we are today. other factors in a balance sheet recession -- notably the lack of private sector loan demand as the private sector attempts to improve balance sheets and the lack of borrowers creditworthy on the stricter standards of banking resultant of banks protecting themselves from further losses -- are driving net financial assets down in a secular deleveraging. and there can be little doubt that we are in fact deleveraging.

ft alphaville highglights the steepening US curve along with a multifaceted take on how the shape of the curve could influence bank behavior, but the critical observation remains that there is no loan demand -- that is, loan demand is net negative, with the private sector preferring even with very low interest rates to reduce debt -- meaning that the steep curve the federal reserve is trying to engineer will have no beneficial effect.

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With the Federal Reserve embarking on QE2, aren't they trying to bring rates down on the long end vs trying to steepen the yield curve?

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i think if they were really intent on flattening the curve, anon, they'd be buying the longer maturities. as it is, their average maturity purchase is intended to be in the 5-year range.

they're trying to have their cake and eat it too -- pushing liquidity, but keeping the 5s30 as wide as they dare to aid bank recapitalization and incentivize lending.

it won't work as an economic stimulant. chris whalen has been vocal on the point that credit demand isn't there, and now ZIRP is cutting down dollar interest revenues dramatically even with a wide percentage NIM. and i think pragcap has effectively explained the futility of QE under these circumstances.

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I would imagine the average duration of bank assets matches the belly of the curve. So the Fed's actions would have initially hurt bank profitability.

IMO, the Fed focused its buying on shorter maturities to avoid taking on duration risk. In effect, they bet that bond investors would be forced further out on the curve as 5-7yr yields plunged. First, that bet unraveled as long end yields rose; then, today, even the 5yr maturity backed up. What a mess!

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the thing is loaded with unintended consequences, isn't it? one of the hazards of having it so well telegraphed and thereby frontrun. they really disappointed those in the long end.

the fed's indifference to systemic income is really frightening as well. the desire to manipulate asset values in an effort to reverse balance sheet damage is understandable -- but there's no recognition of the collapse of interest income which compounds the leakage of income into debt repayment. deflationary side effects...

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Monday, November 08, 2010


LEI deconstructed, update

following on standard analysis previously discussed, conference board leading economic indicators (.pdf) with monetary factors removed continued to deteriorate in september.

here also is the component contribution breakdown, month-by-month. top chart is the "real economy" factors, bottom the excluded "monetary" factors. obviously the distorted yield curve has been the primary difference.

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Friday, November 05, 2010


EMRATIO issuing a warning

i've already gone through a bear case for leading indicators, and that remains unchanged. now i want to examine another indication of economic weakness that played a major role in forecasting a recession in september 2007 -- EMRATIO.

the bureau of labor statistics publishes the ratio of its estimate of the employed population against the total population of the country on a monthly basis in the non-farm payrolls report that was released this morning. while the headline figure of payrolls was a positive surprise, the EMRATIO, as it's known, headed lower alongside labor force participation, retreating to 58.3%.

this is, incidentally, down from a highwatermark of 64.7% in 1999 and 63.5% in 2007 -- the implication being, in a country of nearly 300mm souls, over 15mm people have lost their jobs (voluntarily or no) since the start of the depression.

anyway, it is the change in EMRATIO that can act as a convincing indication of the onset of recession. EMRATIO has now fallen about nine-tenths of the percent from its april peak reading. this graph illustrates all comparable declines in EMRATIO from a local peak back to 1966.

as you can see, EMRATIO hasn't backed off its local peak to this degree without entering a recession since the mid-1960s. and it is worth noting that the united states was a very different kind of employer fifty years ago than it is today -- while manufacturing output has remained around 15% of total output over the years, the fraction of the workforce employed in the highly-cyclical and therefore more-volatile manufacturing sector has been radically reduced by mechanization. in other words, in a service economy the level of employment tends to be somewhat stickier -- it was easier to generate a drop in EMRATIO in the 1960s than today, and the volatility of the series back then reflects that.

so what are the possible positive spins of this development? the onset of the retirement of the baby boomers -- a person born in 1945 turned 65 this year -- is likely to tip the trend down in EMRATIO as a product of natural demographics. so it is likely that dips in the ratio will be steeper than was normal for the period from 1970 until recently. there's also been reports of significant migration out of the united states of foreign workers from latin america as jobs have become very difficult to find, changing the cost-benefit of leaving one's family. to the extent that such people are captured by the report, that exodus might have an effect on EMRATIO, though it would be difficult to quantify.

but it's also worth noting that these effects, regardless of their source, still represent a relative decline in the number of workers in the united states. many have cited the ageing demographics of japan as a contributing source of their twenty-year economic malaise and the repeated and persistent disappointments that have characterized it, helping to drive the deleveraging of the yen economy. just because declines in EMRATIO may not be entirely a result of net corporate firings does not make them economically positive.

moreover, consider that if a lack of available labor was really the driving force behind the drop, one would expect to see accelerating costs of employment as well as jobs-hard-to-get measures being relatively low. clearly that isn't the case now. to the contrary, the pace of increase of average hourly earnings YoY is near a local low (EDIT: krugman makes this point today as well) while the conference board survey of consumer confidence indicates "jobs hard to get" rose in the most recent report to 46.1% of respondents, stubbornly high and near its cyclical peak.

all things considered -- particularly in the context of very slow and fading real final sales, the consumer metrics institute leading data and the leading economic indicators excluding the yield curve -- this contraction in EMRATIO is guilty until proven innocent. we can all certainly hope for a benign outcome, but my expectation continues to be for a return to recession (and possibly a surprisingly deep one) in coming quarters.

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Given your outlook, where are you invested (or where would you be, if you were?) I'm not looking for any secrets, but it seems to me that cash is not where you'd be, unless I'm reading you wrong?

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i'm not a great trader, john -- you'll probably get better advice elsewhere. i'd expect treasuries and cash to do best in any economic downturn as core deflation would have to come to the fore.

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