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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.
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Twiggy Bitchez
http://en.wikipedia.org/wiki/Twiggy
Hehe, showing your age there, CD. Don't touch what you can't afford...
OMG coggydoggy, i wanted to be twiggy so bad. i even ironed my hair to make it straight instead of curly. sick, sick, sick. she was english, that is what i really liked about her.
The Muslim dream of a Sharia (interest-free) world becomes reality.
they just sell zero coupon bonds and call it interest free.
Interesting analogy between the Cash-for-Clunkers program, and the Feds actions of substituting leverage for balance sheet repair. That sums things up quite nicely.
Also interesting are the comments that at least some of these PhD Economists are actually starting to recognize the significance of Credit. I wonder how far they'll take that, since the implications are not appealing, nor in line with the current mainstream thinking.
Embarrasing to realize that the equations were never balanced. Equilibrium was misunderstood. Falls into the "oops, maybe I can sweep this under the rug" category. Maybe no one will notice. Sshhhhh.
Apparently Greece didn't get the memo. In case you're wondering one of my nicknames is "the ankle biter who won't unlatch." TABWWU for short.
yield curves will literally flatten
. . . our flatulent future.
If nothing else, it will be interesting to watch the Fed flatten the yield curve in order to kick the can in 30 year increments (or even 100 eventually?) while keeping it just steep enough to enable their TBTF friends an apparent revenue stream.
Of course, this will kill all other financial institutions who rely on interest revenue, but hey, they had to do SOMETHING!!!
The real gem from this piece is the fact that there is developed world coordination....
Or rather there is a mathematical constant... albeit change...
The constant being continual coordinated developed economy shifts....
Tide goes up raises all ships....tide goes down lowers all ships....
Apparently we've been relocated to the Bay of Fundy:
http://en.wikipedia.org/wiki/Bay_of_fundy
My parents took me there once when I was a kid and we walked around on the drained harbor bed, surrounded by all of the grounded boats, no standing water in sight. It was really weird!
kinda' like a pre-tsunami slurp of all of the water.
- Ned
They'll flatten for only so long, maybe 6months to 1 year. After that we have deflation with a steeply rising yield curve. Welcome to the end game!
This title of this thread was made for RobotTrader!
I am waiting for a 3.5% 30 year mortgage to finance my house. I paid off my Mortgage but would finance to the limit if I coul get 3.5%. I will then wait about a year for Hipper Inflation and put the Money in the Bank for 8% or higher Interest. Happened under Volker. I rememeber 14% Money Market accounts.
Well that is what I am waiting for. It appears from Rick Santelli this morning he is worried about this. And, I happen to agree. Just look at all of the Investors that hold higher Interest notes. They will get paid off and have to lower the yeld on their Money. Another stab in the heart of the fixed income investor. Seniors.
Boy, seems like an anit Senior world with Wall Street and Bernankie. They want to lower or take away Social Security and pay down the National Debt that was caused by the Money printed to bail out the Banks and Pay their Billions in Bonuses. ZIRP (zero percent interest in the bank) for Seniors that cannot afford to lose the little Money they have left from the 2000 Tech Crash, The September 11th attack, the 2008 Financial Meltdown. So, now they want to Retire without losing all of their security and Money (what is left) the banks want to confiscate their Social Security that they paid into for 50 years.
GIVE ME A BREAK.
Last print EUR/USD 1.2822. Where is Taylor´s sell-off ? Still waiting...yawn.
Isn't QE2 already priced into the markets?
If the 30 year bond goes to zero, the yield curve would invert, the dip would double, and stock multiples would expand. Makes perfect sense to me. <sarc off>
Last 40 years, negative real rates mean rising gold prices. The more negative the real rate the bigger the rise in gold. That's computed by subtracting the 90 Day T-bill from CPI. We are there now, and have been for some time. What if the whole curve offers negative real rates? Just asking.
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