Friday, August 19, 2011

New Yield Curve Numbers

So I have been tracking the Yield Curve closely this month.  The spread between the long and the short rates are closing.  In other words, the curve is flattening.  Right now this movement is due to the long-rates falling because the short-rates are pinned to the floor by the Fed.

The short rates I have been tracking are the 3-mo and 1-yr T-Bills.  I am looking at their spread with the 10-, 20-, and 30-yr bonds.  As of today (Aug. 18), the spreads with the 10- and 20-yr bonds are smaller than they were before QE2.  The 30-yr spread is 8 and 9 basis points above the low, less than a year ago.

While some may argue that the spread is still fairly wide, and it is, I do not think that this is a stable gap.  Some spreads this large took more than a year to close, but sometimes it has taken less than a year. 

The key for reading this indicator is whether the short-rates start to rise.  If they do, then that is the clear indicator we are looking for.  However, this might be disguised by the Fed actively manipulating the yield curve.  If it is doing this, then the yield curve is no longer a predictor of the health of the economy.


John Hawkins said...

I was wondering if you could comment on how the various wicksell and fisher effects would play out if the central bank injected money somewhere other than overnight inter-bank loans and instead bought treasuries of a longer maturity. My intuition is that it would flatten and raise the curve. The reason I ask is because I suspect this is what Ben is doing, and what is happening now is that the curve is flattening but is also at a lower base. Could it be the Fed is being that big of a player in the economy that the "Wicksell" effects are dominating so much? How long can this last?

P F Cwik said...


I believe that you are right about the Fed fiddling with the Yield Curve. They know that it is a powerful predictor. If it inverts, they know the game is up.

For long-rates to come down, money has to flow into the longer-term securities (the Wicksell Effect) at a rate greater than the expectation of future inflation (the Fisher Effect). Today, the YC has been flattening showing that the Wicksell Effect is dominating the Fisher Effect.

One key point to remember is that when the YC inverts, it is not due to falling long-term rates. Rather, it inverts from the rise of short-term rates. If the long-term rates are lower, then it takes less movement for the short-term rates to invert the YC. The actions of the Fed, by keeping long-term rates low, are setting themselves up for a quicker future inversion. Currently, the Fed is squashing the short end. And as a result, that money is flowing into the longer end.

Now, what causes the short-term rates to rise? The short answer is a credit crunch. The Fed is keeping the short-rates low, but sooner or later, there will be a real resource crunch, which will manifest itself in the form of rising input prices. There will be a scramble to get more money to bid for those resources. If the Fed accommodates, the cycle goes around again. This is what we are currently doing. Eventually, there will be a breaking point of having too much price inflation and the Fed will stop.

When and where is this point? Who knows. That is a political decision, not an economic one. So your guess is as good as anyone's.

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