The yield curve is often portrayed as one of the most reliable indicators of the economy’s future direction. Why is this the case? More importantly, what can and can’t it tell us?
Which takes us to the second form of real money, bank loans.
We already know that an inverted yield curve signals that liquidity conditions are tight in the near term relative to the long, meaning that demand for short term borrowing is high.
In other words, a shortage of money.
As was the case with fiscal stimulus, the quicker real money gets injected into the economy, the better. This means that contrary to how they’ve behaved in the past, and continue to behave, banks need to be making more loans precisely when they least want to.
Obviously, this is a massive contradiction and conflict of interest. On one hand we have banks, private enterprises which exist solely to ensure that they remain solvent and able to do business.
On the other, we have the economy as a whole, which is dependent on banks to create money when it is needed most (during recessions). Failing which, businesses who need short term financing to tide them through the economic contraction will fail, sparking a chain reaction of loss jobs, income, and spending.
Needless to say, banks simply won’t lend during a recession, at least nowhere near as freely as they did when times were good.
From their perspective, recessions greatly increase the probability of existing loans running into default, much less new ones. Remember that banks are inherently short convexity, that is, a small number of big defaults can send them under.
As such, it makes very little business sense for them to be taking on increased risk during a period of time which demands more risk-taking prudence.
Unfortunately for the rest of us, this means that the shortage of money in the broader economy doesn’t get alleviated.
As with other problems of a systemic nature, developed economies (and populations) turn to the government for a solution. In the case of recessions, this means central banks – if private banks won’t inject money into the economy, surely the central bank will!
To their credit, central banks, especially in developed economies, have really stepped up to try to do so.
The means through which they have tried to pump money into the economy has, over the years, expanded to the point where what was once deemed unorthodox is now common practice.
Their toolkit now ranges from the humble interest rate cut to ultra low interest rates, negative interest rates, and of course the biggest monetary bazooka of them all, QE.
To their discredit, none of it has really worked. While they, and others, will point to improving data and economies rebounding from recession as proof that their policies have worked, it is quite easy to see that they really don’t.
To be continued…
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…
The second reason the yield curve can’t really tell us the depth of a future recession is because of external shocks.
For some reason, or just out of randomness, large negative shocks tend to materialize when global economic conditions take a turn for the worse.
As Shakespeare so succinctly put it,
When sorrows come, they come not single spies. But in battalions!William Shakespeare, Hamlet
In terms of economies both domestic and international, Shakespeare’s battalions take the form of natural disasters and/or man made disasters occurring at the worst possible time. Examples of this include the Dust Bowl during the Great Depression, COVID sweeping across the globe in 2020, and Russia’s invasion of Ukraine in 2022.
Exogenous events like these can make recessions worse in a variety of ways.
In the case of natural and man made disasters (war), property is destroyed and jobs (as well as lives) are lost. If the disaster is large-scale enough, like the Dust Bowl, entire regions can be put out of work having lost their livelihoods.
The loss of the region’s production reduces its supply in domestic, if not global, markets. This second order effect drives up prices, giving rise to inflation during a time where people are struggling to find, if not losing, jobs.
The result? Even more economic pain and a deeper, more prolonged recession.
The same applies to war, where the entire economic output of a country can plummet overnight, taking many years to recover. As the world is discovering right now, the more important a country’s role in supplying today’s highly globalized markets, the more everyone else feels the pain.
As the supply of food and raw materials has become increasingly disrupted by Russia’s invasion of Ukraine, prices of food, energy, and raw materials have soared.
Higher prices for consumers, and costs for businesses, is the last thing the global economy needs when the yield curve is signaling tightening monetary conditions.
Simply because in a “normal” recession, the businesses that suffer the most are those which are over indebted, have poor or non-existent cash buffers, or fail to manage their costs properly.
In other words, they are the weakest companies, or companies with the weakest business models, in the economy. When a recession rolls along and they fail to raise money in a timely manner, these companies quite naturally go bankrupt.
Call it the Law of the Jungle or Creative Destruction, it’s just how things work in modern economies.
Now, when an exogenous shock coincides with a recession, the lost jobs and livelihoods further reduce business and consumer spending, which were already tumbling.
This fall in economy-wide demand sucks the companies that wouldn’t “normally” be considered weak into the desperate scramble for capital, even as banks are cutting back on lending.
The same thing happens when the exogenous shock leads to higher prices. Businesses which had managed their costs well suddenly find themselves having to deal with a spike in costs that wasn’t foreseen, much less planned for.
This spike in costs, together with lower levels of demand in the economy, erode their margins. They end up having to raise new capital in an environment where few banks and investors want to take on risk, and many end up going bankrupt.
While such businesses and their employees might feel aggrieved, as they would not have gone down in a “normal” recession, we live in a Pareto World. Fat tailed black swan events happen more often than we think, or like.
Ultimately, the yield curve cannot predict such exogenous shocks, or the efficacy of governmental intervention.
All it can tell us is that something is wrong in the economy, as reflected by the demand for money outstripping banks’ willingness to supply it.
To be continued…
Let’s conclude our discussion on the yield curve with the role of central banks, namely the Fed.
Where is the Fed, and it’s supposed control over interest rates in the previous parts of our discussion?
Central bank policy’s effect on rates is slightly more difficult to understand due to the widespread myths that surround it. The vast majority of market participants believe that the Fed (and other central banks) control interest rates, and as such, believe that rates move on their whim.
In practical terms, this translates into two different forces.
The first is traders and investors reacting to the Fed, driven by their belief that what the Fed does matters. This is easily observed by rates surging or plummeting immediately after the FOMC makes a policy announcement. (Or a voting FOMC member makes a speech).
The second is, of course, what traders and investors in the US Treasury (UST) markets are actually doing, which is a combination of a whole host of complex factors and interactions.
These include, but are not limited to, the demand for collateral in the global financial system, participants’ outlook for interest rates, how financial institutions are hedging their books, and the supply of USTs auctioned into the market by the government, to name a few.
A simple way to grasp how the two forces, reactions and what the market is actually doing, are interacting with each other is to use the Iceberg Model.
Fed announcements and policy changes are represented by “Events”, which are the most visible part of a complex system, hence why everyone talks and writes about them.
What the market is actually doing is represented by “Patterns Of Behavior”, which in the context of markets, refers to trends.
If interest rates, that is yields, not bond prices (the two are inversely related) are trending higher prior to a Fed announcement, we know that it is more than likely that they will continue to trend higher.
Because, as mentioned earlier, what the Fed does doesn’t really matter.
This can be empirically observed by looking at turning points in US 2y yields and the Fed Funds Rate. Historically, the Fed has lagged the UST market.
In other words, the Patterns Of Behavior, i.e. trends, in the market matter more than the Events.
How does all of this relate to the shape of the yield curve?
To be concluded…
It is widely believed that the Fed only controls “short term” rates. “Short term” in conventional market wisdom means up to the 2 year mark on the yield curve, that is, US 2y yields.
Hence, yields up to the 2y mark are “supposed” to move the most when the Fed changes the Fed Funds Rate.
By extension, longer term bonds are seen as sitting outside the Fed’s zone of “influence”. Which simply means that the longer tenor the UST, the less it is affected by the Fed’s interest rate policies.
For the sake of specificity, since we have emphasized that the Fed doesn’t really matter: the longer tenor the UST, the less it is affected by the market’s Pavlovian reaction to the Fed.
This key difference between 2y and 10y USTs is where the Fed’s policies meet economic and market reality.
Since the Fed “controls” the front end of the curve, and not the back, the spread between short and long term yields (like the 2s10s) actually indicate to us what the market thinks will happen in the broader economy.
What’s happening in the yield curve now provides us with a good example of this. US 2y yields are rising by more than 10y yields, which has given rise to a flat yield curve that inverted across multiple tenors in early April.
2y yields are rallying strongly as the market responds to the Fed’s continued jawboning and uber-hawkish rhetoric. 10y yields, however, are not as sensitive to all of this, and aren’t rallying as quickly.
What is truly striking is that the rally in 10y yields can’t keep up with the rally in 2y yields, even though inflation is running very high. (recall that 10y yields are much more sensitive to changes in inflation) 2s10s falling below 0 in early April proved this.
Logically, if 2y yields rise above 10y yields during a hiking cycle, it means that the market is pricing in a rate of long term inflation that is lower than Fed driven short term interest rates. In other words, the market is not expecting the economy to grow. At least not to the point where it generates enough “good” inflation.
It is this “ability”of the yield curve to absorb and distill complex global market interactions, while still acting as a reliable early economic warning system, that makes it so invaluable to traders and investors.
That being said, the yield curve should not be taken too literally. Firstly, it can’t really tell us how deep a future recession will be, as explained earlier in this series.
Secondly it is a market based measure, which means that it is susceptible to short term market “noise”. As such, it isn’t the case where the yield curve will, once inverted, stay inverted until recession comes along.
Instead, it bounces around like all other market prices, first inverting, then un-inverting, and possibly re-inverting again. The key here, as it is with trading every other market, is to focus on the trend, not the short term event driven gyrations.
Ultimately, for all the yield curve’s limitations, and our inability to figure out the complex web of individual market interactions that drive it, a broad macro view of what its shape represents is enough for general purposes.
Of course, investigating and understanding the nuances of what moves UST yields, and hence the shape of the curve, will give one greater insight into how global markets function. But, for those less inclined, understanding what flat, steep, and inverted represents is good enough.
Get a different perspective on all things trading & investing every week!