What Is The Yield Curve? Why Is It Important? 7
The way to see that central bank policy is doomed to be ineffective is to understand how modern monetary policy really functions.
Today’s central banks rely almost exclusively on bank reserves as a policy lever. This means that their moves to increase or decrease interest rates, or to pump “money” into the economy, are all based on bank reserves.
And they have done so, with trillions in QE being implemented over the course of the pandemic alone.
Bank reserves aren’t real money.
They aren’t real money because they aren’t lent out. Instead, they sit inert on bank balance sheets, as everyone believes that central banks are taking effective action, even though they are not.
What is perceived as a central bank fueled economic recovery is in actual fact a conflation of epiphenomena. In other words, mistaking correlation and causation.
Modern free markets are termed “free” because they mostly take care of themselves.
As businesses fail, or adapt to harsher conditions, economic conditions naturally recover on their own. Companies shed jobs until their costs are controllable, and consumers cut their spending until their household budgets are balanced.
Over time, confidence returns and banks begin to lend more as folks venture into starting new businesses or expanding existing ones. Incomes rise, spending increases, and the economic cycle begins anew.
This has always happened, all over the world and through the ages. Central banks can help or harm, but ultimately, free economies will sort things out on their own.
All of which takes us back to square one of our problem – the shortage of money in the economy.
If banks are unwilling to make more loans, i.e. create real money, and central banks don’t actually create real money, what can be done?
Since, in our modern financial system, private banks are the ones in charge of creating real money, they have to be incentivized to lend more.
Of course, this is easier said than done, and given how the majority of folks still believe in central bank omnipotence, hasn’t really been explored yet.
That being said, steps were taken during the pandemic which were in the right direction.
Government backed loan schemes, launched in multiple countries across the globe, incentivize banks to keep lending by bearing part of the risk.
By combining official intervention with private sector money creation, these schemes increase the chances of banks creating real money in the economy when it’s needed most. This, at the very least, has a higher chance of really working, as opposed to endless central bank QE.
However, these schemes are relatively new to the modern economic intervention toolkit, and their success is highly dependent on their execution. How much risk are governments willing to take in this crisis, or the next?
How quickly can loans be applied for, processed and approved (or rejected)? What restrictions will governments place on businesses who apply for loans?
These are just a small sample of questions and details that governments and banks must work out together in order for such schemes to have a chance at success in the future.
But, how does all of this relate to the yield curve?
The yield curve, or more specifically, the participants in the global bond markets, cannot and do not know how any such official intervention will play out.
Will officials legislate for fiscal stimulus? If so, how much? Will they back new shared-risk loan schemes with banks? What will the details of such a scheme look like?
Also, since most people still hold fast to the false paradigm of central bank omnipotence, how much QE will central banks embark on?
Lastly, and most importantly, will any of these policies actually have an impact?
The bond market can’t know the answers to all these questions in advance, much less their second order consequences. No one can.
This reality is easily observed in how volatile markets get as conditions worsen and governments choose to roll out (or not) stimulus measures. Such volatility is, at the end of the day, just an expression of traders and investors trying to figure out how to price the interaction of all these complex factors into their respective markets.
The higher the level of volatility, the less certain markets are about what the future will look like, and the yield curve is no exception.
To be continued…
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