John Taylor Muses On A "Supermodel" World Whose Curves Are About To Get Even Flatter
FX Concepts John Taylor explains why as the deleveraging process becomes globalized, he expects global yield curves to "literally" flatten. He also explains why the Jackson Hole view that the Japan analogy is overdone, is wrong. Taylor does not go as far as Michael Pento to suggest that the Fed's next step will be to purchase equities, but its encroachment of the entire treasury curve means the "the Fed is already committed to purchase hundreds of billions of dollars of Treasuries just to maintain its current policy stance, we expect the persistence of weak labor markets to force it to launch “QE2”, further depressing back-end yields." Yet another addition to the "QE is imminent" bandwagon. The only question remains: will the formal announcement be the catalyst to go headlong into risk, and what will that mean for near-term inflation for items that really matter, yet are so conveniently ignored by the Core-CPI.
The World is Flat – and Getting Flatter
September 2, 2010
By John R. Taylor, Jr. / Jim Conklin
Chief Investment Officer
Two pivotal market events in August were the FOMC’s decision to reinvest principal payments from agency debt and mortgage-backed securities in longer-term Treasuries and Chairman Bernanke’s speech at the Kansas City Fed’s annual Jackson Hole conference. Perhaps more than any other indicator, the US Treasury yield curve summarized by the 2-year versus 10-year Notes spread reflected the recent run of weak data and the Fed’s policy announcement, flattening 40 basis points (bps) during the month. It is tempting to say that the move in the curve was overdone and, as cooler heads and steadier hands return from holiday, the US curve will correct and steepen. Just as Bernanke explained in Wyoming, the US recovery is transitioning from being driven by fiscal stimulus and inventory restocking to an expansion supported by household income growth and business fixed investment. If so, with the Fed on hold, short-term rates will remain low and the curve should steepen. Moreover, the 2s10s slope has oscillated between -50 bps and nearly 300 bps since the mid-1980s and it has always flattened as front-end rates rise, not as back-end rates fall. This view argues that the Japan analogy is overdone: US financial sector capital losses were recognized, tallied and re-capitalized rapidly; the Fed is activist and reacted quickly to head-off deflationary risks; Congress and the Treasury supplied fiscal stimulus in an equally timely fashion; and the US has a growing population and a private sector
unburdened by the structural impediments that hamper Japan. As a result, exploding fiscal deficits and expansive central bank policy make inflation the major risk; curves should steepen as a consequence.
Considering the magnitude of the 25 year leveraging cycle and the depth of the crisis, we find the debtdeleveraging counter argument much more compelling. Private credit reached 365% of GDP in the US by late 2008, doubling since 1985. This measure has only recently begun to decrease and if earlier crises are a guide it has a long way to fall. At Jackson Hole, discussion of credit in financial crises and subsequent recoveries was so prominent one would have been forgiven for mistaking Hyman Minsky for Milton Friedman as the dean of the US post-war economics establishment. In one paper, Carmen and Vincent Reinhart analyzed 15 major financial crises since World War I. In half of their sample of countries the level of GDP remained below pre-crisis levels for a decade. The extent of pre-crisis credit growth and its subsequent shrinkage were important determinants of the severity of post-crisis underperformance. Analyzing sources of the crisis, BoE Deputy Governor Charles Bean emphasized Minsky-style logic that the low volatility begotten by the credit expansion itself was a culprit. Both Bean and Bernanke argued that non-monetary prudential regulation is superior to monetary policy for avoiding financial crises in the first place. Just as cash-for-clunkers and housing purchase subsidies merely delayed the day of reckoning for automobile and housing sales, we fear that last year’s substitution of public central bank leverage for private balance sheet repair has merely delayed the full extent of household expenditure adjustment. Given the scale of the credit cycle that just ended, the probability of a double-dip recession is far higher than the historical comparison to other post-war cycles suggests. From a starting point where the Fed is already committed to purchase hundreds of billions of dollars of Treasuries just to maintain its current policy stance, we expect the persistence of weak labor markets to force it to launch “QE2”, further depressing back-end yields.
To draw on Thomas Friedman’s analogy, as the deleveraging process becomes globalized the developed world’s yield curves will literally flatten. Shifts in the yield curve in August are the beginning of a larger trend reflecting weak economic performance well into next year, anticipating central banks’ efforts to counter that weakness.