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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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