Wednesday, January 17, 2018

Update: The Yield Curve and the Business Cycle

Here is a graph of forward treasury rates, which I have inferred from market rates of treasuries of different maturities.  (It doesn't make that much difference.  The forward (10,10) rate, for instance, approximates the 20 year treasury yield.)
idiosyncraticwhisk.blogspot.com  2018

Roughly speaking, I look at the yield curve as having two clear regimes: pre-1980 where monetary policy was pro-cyclical and increasingly inflationary, and post-1980 where monetary policy was decreasingly inflationary and somewhat less pro-cyclical.  Pre-1980, the short term rate would rise late in a recovery phase, but the Fed was generally behind the curve, and so inflation was generally rising fast enough to neutralize the real rate.  So, forward rates tended to rise along with short term rates.  Eventually, at high nominal rates, the yield curve would invert substantially, and inflation would subside with economic contraction.

After 1980, inflation has slowly declined, and there are two types of tightening cycles, according to my highly technical, patent pending method of eyeballing the graph.  There are cycles where forward rates rise along with short term rates, such as in 1983, 1987, 1993, and 1999.  In these cases, rising rates were a reflection of a strengthening economy, efficiencies from a strong labor market, lower premiums for accepting cyclical risk, and maybe some moderate inflation, so the rising short term rate wasn't particularly contractionary.  It was a reasonable reflection of neutral monetary policy.

On the other hand, in 1989, 2000, and 2004-2007, short term rates rose while long term rates declined or remained steady.  In these cases, rising short term rates were more likely to reflect tightening policy than to reflect improving sentiment, and in these cases, falling NGDP growth and recessions followed.

So, the question is, are we in a rising forward rate environment today or a stable forward rate environment?  Clearly, in the broader scheme, forward rates are steady.  This is why I have generally been biased to expect rate increases to be contractionary.  But, forward rates in the post-1980 period have been a bit noisy.  So, it is possible that any uptick in forward rate noise is actually a regime shift to a rising yield curve.  Were the rising rates in late 2016 somehow a product of a new market shift related to the current presidential administration, or just noise?  I would tend to attribute it to noise, but the current political context is unusual, so things are a bit uncertain.  Eventually, I expect the zeal among FOMC members to raise rates will win out, and the yield curve will flatten relative to where forward rates are today, and we will enter a contractionary period.

That being said, the bears - their heads full of perceived bubbles - have not had a good run, and the analysts that strike me as level-headed seem especially sanguine about the next couple of years.  Certainly many indicators seem to be giving benign signals.  But, I think this signal bears watching.  A few years ago, I was bullish, and employment indicators were more of a focus.  Employment will be more of a lagging indicator in a contraction, though, so I think long term rates, inflation, and mortgage expansion are keys to keep an eye on today.  Bulls are correct that there isn't anything inevitable about a yield curve at the current slope, and that extensive expansions have happened with this sort of yield curve.  But, when that has been the case, either short term rates were stable or short and long term rates were rising together.  The low rate of non-shelter inflation and the meager growth of mortgage lending seem like confirming indicators that a defensive bias remains prudent.

3 comments:

  1. Agreed.

    A possible upside is that Powell is a Trump-GOP appointee.

    A Wall Streeter too. A lawyer, not an economist.

    Powell may want the story to be that GOP tax cuts "worked."

    Also, the People's Bank of China and the Bank of Japan are following expansionist regimes and that may keep the global economy on keel.

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  2. http://ngdp-advisers.com/2018/01/18/lawyer-better-fed-chief-fed-plots-higher-unemployment-rate/

    Possible case for optimism.

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    Replies
    1. That line on unemployment. Yikes. Has there ever been a period of time where the unemployment rate gradually increased like that? Goodness.

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