On The Fun (But Pointless) Debate Between Rick Santelli And Rich Bernstein On What The Yield Curve Indicates (In A Time Of Central Planning)
Rich Bernstein who while at BofA used to be one of the few (mostly) objective voices, today got into a heated discussion with Rick Santelli over yield curves and what they portend. In a nutshell, Bernstein's argument was that a steep yield curve is good for the economy, and the only thing that investors have to watch out for is an inversion. Yet what Bernstein knows all too well, is that in a time of -7% Taylor implied rates, QE 1, Lite, 2, 3, 4, 5, LSAPs, no rate hikes for the next 3 years, and all other possible gizmos thrown out to keep the front end at zero (as they can not be negative for now), to claim that the yield curve in a time of central planning, is indicative of anything is beyond childish. A flat curve, let alone an inverted curve is impossible as this point: all the Fed has to do is announce it will be explaining its Bill purchases and watch the sub 1 Year yields plunge to zero. Yet the long-end of the curve in a time of Fed intervention is entirely a function of the view on how well the Fed can handle its central planning role: after all, the last thing the Fed wants is a 30 year mortgage that is 5%+ as that destroys net worth far faster than the S&P hitting the magic Laszlo number of 2,830 or whatever it was that Birinyi pulled out of his ruler. As such, Santelli's warning that a steep curve during POMO times is just as much as indication of stagflation as growth, is spot on.
Furthermore, to Bernstein's childish argument of "where is the stagflation" maybe he should take a look at commodity prices, unemployment levels and double dipping home prices, and the answer will suddenly become self evident. But either way, the point is that during central planning the shape of the curve does not matter at all, and certainly not to banks. The traditional argument that banks make more money on the long end breaks down when nobody is borrowing on the long-end, and with mortgage apps, both new and refi, plunging to fresh lows, that is precisely what is happening. But who cares about facts: all one has to do is roll one's eyes and smile flirtatiously at Becky Quick (making sure of course that Warren is nowhere to be found).
The video of the argument between the two is below:
Regardless, while Bernstein's objectivity is now sadly very much under question, if understandably so as his new business requires a bullish outlook no matter what, here is a primer on curves that was posted on Zero Hedge previously for all those who may have been confused by today's debate.
Posted on Zero Hedge in June 2010:
Why the Yield Curve May Not Predict the Next Recession, and What Might
Gone Are the days when "green
sh#%ts" was bleated daily on CNBC amongst a chorus of permabull snorts.
Even the experts now recognize the recovery as a BLS swindle,
and it is important to reintroduce the possibility of not only a low growth
future, but one of outright and persistent contraction. As “double dip” has recently worked its way into
the popular lexicon, we will explain why a traditional forecasting tool of
recessions may not flash a warning this time around. Afterward, we explore why
even “double dip” may not be an accurate term, as well as what a cutting
edge-new economic indicator is forecasting.
Gary North wrote an excellent article explaining why yield curve
inversions predict recessions. It is instructive now to illustrate how the
fundamental backdrop has changed amidst unprecedented government intervention.
The interest rates for more distant maturities
are normally higher the further out in time. Why? First, because lenders fear a
depreciating monetary unit: price inflation. To compensate themselves for this
expected (normal) falling purchasing power, they demand a higher return.
Second, the risk of default increases the longer the debt has to mature.
In unique circumstances for short periods of
time, the yield curve inverts. An inverted yield occurs when the rate for
3-month debt is higher than the rates for longer terms of debt, all the way to
30-year bonds. The most significant rates are the 3-month rate and the 30-year
The reasons why the yield curve rarely inverts are simple: there
is always price inflation in the United States. The last time there was a year
of deflation was 1955, and it was itself an anomaly. Second, there is no way to escape the risk of default. This risk
is growing ever-higher because of the off-budget liabilities of the U.S.
government: Social Security, Medicare, and ERISA (defaulting private insurance
plans that are insured by the U.S. government).
We are no longer in a persistently
inflationary environment, despite the best multitrillion-dollar reflationary
efforts to the contrary. Disinflation and outright deflation keep popping up in
critical areas of the economy. While the central banks will likely overshoot in
the end, resulting in an hyperinflationary spiral, for the time being, lenders
are not worrying about inflation. And, while one may doubt the BLS’ calculation
expressed by the Consumer Price Index, the below chart of CPI year-over-year is
nonetheless striking, as it indicates the recent crisis brought it into the
most negative territory since inception.
On the rise are medical and food costs, but
continued deleveraging by banks and consumers are offsetting deflationary
drags. Banks are writing down (and off) private and commercial real estate
loans, and consumers will remain in spending retrenchment as long as they
continue to work off credit in a high unemployment environment. Indeed, year
over year consumer credit is in the most negative territory post-WWII.
Though headline civilian unemployment from the
BLS’ household survey is ticking down from the ominous 10% level, this is
largely a result of the birth/death model adjustmentand the removal of
so-called discouraged workers from the counted pool. When viewed from the
larger perspective of the civilian employment to population ratio, the job
losses are staggering and unprecedented in the modern era. When the economy
eventually does show improvement, these discouraged workers will reenter the
job market and keep the headline unemployment rate persistently high.
Finally, creation of money supply, as expressed
by non-seasonally adjusted year-over-year M2, continues to reflect slow money
growth, notwithstanding the trillion or so in excess bank reserves sitting at
the Fed earning interest at 0.25%. The very fact that banks are content to earn
interest at this absurdly low rate indicates risk aversion and little fear of
What does an inverted yield curve indicate? This: the expected
end of a period of high monetary inflation by the central bank, which had
lowered short-term interest rates because of a greater supply of newly created
funds to borrow.
The obvious failure of the central banks to
reflate the economy has now renewed fears that monetary
inflation will not return for some time.
This monetary inflation has misallocated
capital: business expansion that was not justified by the actual supply of
loanable capital (savings), but which businessmen thought was justified because
of the artificially low rate of interest (central bank money). Now the truth
becomes apparent in the debt markets. Businesses will have to cut back
on their expansion because of rising short-term rates: a liquidity shortage. They
will begin to sustain losses. The yield curve therefore inverts in advance.
On the demand side, borrowers now become so desperate for a loan
that they are willing to pay more for a 90-day loan than a 30-year, locked
Aside from government darlings, businesses and
critically, small businesses, have largely stopped expanding and are in
defensive retrenchment. The problem is a reduction in both the supply and demand for new loans. There is definitely a
liquidity shortage, but it is being expressed unconventionally as central bank
quantitative easing and government stimulus are directed into non-productive
parts of the economy. It is these zombie behemoths in the financial and
transportation sectors that are most desperate for funds, yet they are not
penalized for it. Instead, they are encouraged to feed at the government trough
even as their smaller (and more productive) competitors are edged out through
oppressive regulation and inability to access loans at a similar rate. This
will continue to be a drag on overall growth, and without small business
growth, the threat of recession relapse is greatly heightened.
On the supply side, lenders become so fearful about the short-term
state of the economy -- a recession, which lowers interest rates as the economy
sinks -- that they are willing to forego the inflation premium that they
normally demand from borrowers. They lock in today's long-term rates by
buying bonds, which in turn lowers the rate even further.
Though long term US Treasurys are benefitting
from safe haven flight-to-quality status, short term Treasurys are similarly
benefitting to a greater degree, thus widening the spread between the two. As
stated above, banks are content to park over a trillion dollars in excess
reserves at the Fed earning interest at 0.25%. A combination of a (currently
low but slowly rising) fear of eventual US default, extreme desire for short
term safety in T-Bills, and low fear of inflation is keeping the spread wide.
Also troubling is the recent disconnect between short term Treasury yields and
the borrowing rates actually available to businesses with excellent credit.
An inverted yield curve is therefore produced
by fear: business borrowers' fears of not being able to finish their on-line
capital construction projects and lenders' fears of a recession, with its
falling interest rates and a falling stock market.
Indeed, these are the fears being expressed,
but in different manners that are not immediately obvious. Small productive
businesses are throwing in the towel as their larger competitors build Potemkin
A further problem is that nearly all yield
curve studies look back no further than the mid-1950’s, the inception of Fed
data on US Treasury rates. Inasmuch as every recession since then (save the
last) has been manufacturing based as opposed to credit based and has occurred
in an overall inflationary backdrop, there lacks a crucial window into prior
deflationary times concurrent with extreme government meddling—in particular,
the Great Depression.
Many economists from the Austrian school
follow M2 money supply as a harbinger of economic growth or contraction, as it
tracks the creation and destruction of money through economic activity at the
margins. As noted previously on EPJ, Rick Davis and others
at the Consumer Metric Institute have created a novel indicator that tracks, in
real time, consumer demand for capital goods. Accordingly, it should and does
reflect similar activity, though with enhanced granularity. Indeed, it anticipates
US GDP by an average of 17 weeks. A future post will explore this aspect of
their data and possible uses for market timing. For now, Davis tells
a different story than the governments that collude to forge a
Our 'Daily Growth Index' represents the
average 'growth' value of our 'Weighted Composite Index' over a trailing 91-day
'quarter', and it is intended to be a daily proxy for the 'demand' side of the
economy's GDP. Over the last 60 days that index has been slowly dropping, and
it has now surpassed a 2% year-over-year rate of contraction.
The downturn over the past week has emphasized
the lack of a clearly formed bottom in this most recent episode of consumer
'demand' contraction. Compared with similar contraction events of 2006 and
2008, the current 2010 contraction is still tracking the mildest course, but
unlike the other two it has now progressed over 140 days without an
As we have mentioned before, this pattern is unique and unlike
the 'V' shaped recovery (or even the 'W' shaped double-dip) that many had
expected. From our perspective the unique pattern is more interesting than the
simple fact of an ongoing contraction event. At best the pattern suggests an
extended but mild slowdown in the recovery process. But at worse the
pattern may be the early signs of a structural change in the economy.
While confounding the average GE cheerleader,
this new normal of increasing destructive intervention is intuitively
understood by the consumer, who responds to this reality by pocketing the debit
card. So what can we expect in the ensuing quarters?
Davis aptly describes what has happened so
[I]t has instead, unfolded so far as a mild but persistent kind
contraction, more like a 'walking pneumonia' that keeps things miserable for an
extended period of time.
Until governments stop
punishing innovation, stop rewarding incompetence, stop distorting economic
signals with arbitrary econometric targeting, stop coddling failures--we will
continue to walk with this pneumonia indefinitely. The solution, as always, is nothing.
Stop intervening and let the chips fall where they may. Markets will correct
than you might think.
And here is a useful primer from Fidelity on the various shapes of the yield curve and what they indicate:
Normal and Not Normal
Ordinarily, short-term bonds carry lower yields to reflect the fact that an investor's money is under less risk. The longer you tie up your cash, the theory goes, the more you should be rewarded for the risk you are taking. (After all, who knows what's going to happen over three decades that may affect the value of a 30-year bond.) A normal yield curve, therefore, slopes gently upward as maturities lengthen and yields rise. From time to time, however, the curve twists itself into a few recognizable shapes, each of which signals a crucial, but different, turning point in the economy. When those shapes appear, it's often time to alter your assumptions about economic growth.
To help you learn to predict economic activity by using the yield curve, we've isolated four of these shapes -- normal, steep, inverted and flat (or humped) -- so that we can demonstrate what each shape says about economic growth and stock market performance. Simply scroll down to one of the curve illustrations on the left and click on it to learn about the significance of that particular shape. You can also find similar patterns within the past 18 years by running our "yield-curve movie" and -- by clicking the appropriate box -- you can compare any shape within that time period to both today's curve and the average curve.
Date: December 1984
When bond investors expect the economy to hum along at normal rates of growth without significant changes in inflation rates or available capital, the yield curve slopes gently upward. In the absence of economic disruptions, investors who risk their money for longer periods expect to get a bigger reward -- in the form of higher interest -- than those who risk their money for shorter time periods. Thus, as maturities lengthen, interest rates get progressively higher and the curve goes up.
December, 1984, marked the middle of the longest postwar expansion. As the GDP chart above shows, growth rates were in a steady quarterly range of 2% to 5%. The Russell 3000 (the broadest market index), meanwhile, posted strong gains for the next two years. This kind of curve is most closely associated with the middle, salad days of an economic and stock market expansion. When the curve is normal, economists and traders rest much easier.
Date: April 1992
Typically the yield on 30-year Treasury bonds is three percentage points above the yield on three-month Treasury bills. When it gets wider than that -- and the slope of the yield curve increases sharply -- long-term bond holders are sending a message that they think the economy will improve quickly in the future.
This shape is typical at the beginning of an economic expansion, just after the end of a recession. At that point, economic stagnation will have depressed short-term interest rates, but once the demand for capital (and the fear of inflation) is reestablished by growing economic activity, rates begin to rise.
Long-term investors fear being locked into low rates, so they demand greater compensation much more quickly than short-term lenders who face less risk. Short-termers can trade out of their T-bills in a matter of months, giving them the flexibility to buy higher-yielding securities should the opportunity arise.
In April, 1992, the spread between short- and long-term rates was five percentage points, indicating that bond investors were anticipating a strong economy in the future and had bid up long-term rates. They were right. As the GDP chart above shows, the economy was expanding at 3% a year by 1993. By October 1994, short-term interest rates (which slumped to 20-year lows right after the 1991 recession) had jumped two percentage points, flattening the curve into a more normal shape.
Equity investors who saw the steep curve in April 1992 and bet on expansion were richly rewarded. The broad Russell 3000 index (right) gained 20% over the next two years.
Date: August 1981
At first glance an inverted yield curve seems like a paradox. Why would long-term investors settle for lower yields while short-term investors take so much less risk?
The answer is that long-term investors will settle for lower yields now if they think rates -- and the economy -- are going even lower in the future. They're betting that this is their last chance to lock in rates before the bottom falls out.
Our example comes from August 1981. Earlier that year, Federal Reserve Chairman Paul Volker had begun to lower the federal funds rate to forestall a slowing economy. Recession fears convinced bond traders that this was their last chance to lock in 10% yields for the next few years.
As is usually the case, the collective market instinct was right. Check out the GDP chart above; it aptly demonstrates just how bad things got. Interest rates fell dramatically for the next five years as the economy tanked. Thirty year bond yields went from 14% to 7% while short-term rates, starting much higher at 15% fell to 5% or 6%. As for equities, the next year was brutal (see chart below). Long-term investors who bought at 10% definitely had the last laugh.
Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown -- or outright recession -- as well as lower interest rates across the board.
Flat or Humped Curve
Date: April 1989
To become inverted, the yield curve must pass through a period where long-term yields are the same as short-term rates. When that happens the shape will appear to be flat or, more commonly, a little raised in the middle.
Unfortunately, not all flat or humped curves turn into fully inverted curves. Otherwise we'd all get rich plunking our savings down on 30-year bonds the second we saw their yields start falling toward short-term levels.
On the other hand, you shouldn't discount a flat or humped curve just because it doesn't guarantee a coming recession. The odds are still pretty good that economic slowdown and lower interest rates will follow a period of flattening yields.
That's what happened in 1989. Thirty-year bond yields were less than three-year yields for about five months. The curve then straightened out and began to look more normal at the beginning of 1990. False alarm? Not at all. A glance at the GDP chart above shows that the economy sagged in June and fell into recession in 1991.
As this chart of the Russell 3000 shows, the stock market also took a dive in mid-'89 and plummeted in early 1991. Short- and medium-term rates were four percentage points lower by the end of 1992.