The most important characteristic of current capital markets, aside of course from now completely irrelevant stocks, which there is no point in even discussing any more as the Russell 2000 has become nothing more than a policy tool for Bernanke in pitching idiot Congressmen how "successful" his failed monetary policy has been when all it indicates is how good he is at manipulating stock prices, is the record steepness of the yield curve, as we have been pointing out month after month (oddly the topic never gets boring as it hits a new record wide with each passing month). And while to Ben the steepness is simply more good news to regale his questioners, who have no idea what the difference between a bond price and yield is, with, it is just as easily the most bearish indicator available. Nick Colas explains why "the bears also have more fodder from the steep yield curve than an Alaskan salmon run: the long end of the curve could be blowing out over inflation fears, persistent government debt issuance, or even a future downgrade of U.S. sovereign debt." But don't worry- the Chaircreature will never acknowledge that there is a yang to every ying. Especially not when the ying has to be so well priced, that Bernanke's midichlorian count has to be off the charts to get his liquidity extraction timing perfectly and avoid either a hyperdeflationary or hyperinflationary collapse.
From BNY Convergex: Smoke from a Distant Fire, or what the 2s10s really indicates
Summary: The U.S. Treasury yield curve is setting records for its “steepness” – the difference between short duration yields and those that stretch out for 10 to 30 years. The current yield spread between 2-year and 10-year notes is now 290 basis points. We’re clearly in record-setting territory, but this is one of those data points that seems to fully support both full-on bullish and bearish viewpoints. History is on the side of optimism: the two previous periods of Matterhorn-like yield curves were in the early 1990s and 2000s and served as precursors to an improving U.S. economy and large gains for stocks. Yet the bears also have more fodder from the steep yield curve than an Alaskan salmon run: the long end of the curve could be blowing out over inflation fears, persistent government debt issuance, or even a future downgrade of U.S. sovereign debt. This argument will be settled by how much loan growth we see in the banking system, for that is the way steep yield curves traditionally catalyze economic growth.
“People only see what they are prepared to see.” That quote comes from Ralph Waldo Emerson, the American 19th century writer and philosopher. While he meant it largely in a spiritual sense – his first vocation was in ministry – there is much truth to it when it comes to the world of investing. You only have to look as far as the tech and housing bubbles or the Financial Crisis to see that human judgment is strongly colored by what we want to see. What we are “Prepared to see.”
Nowhere is that sentiment more accurate than in the current state of the U.S. Treasury bond market. Let’s start with the facts of the case:
- Most investors consider this to be one of the most efficiently priced markets in the world. There’s plenty of supply, first of all, with $9.5 trillion in public hands. And then there’s a healthy leverage component – even a retail Fidelity margin account will allow you to buy more than 4x your cash balance. An accommodating prime broker will give you far more leverage without much of a fuss. Even before you layer on a robust futures market, the monthly trading in U.S. government bonds totals some $500 billion every month.
- The short end of the Treasury curve, less than 2 years or so maturity, is largely controlled by interest rate policy driven by the Federal Reserve. They set short-term rates with their decisions on the Federal Funds rate, the overnight interest rate used by banks to lend money to other financial institutions.
- The yields at the long end of the curve, essentially 5 – 30 years, are determined primarily by expectations for future inflation. U.S. Treasuries have long been considered “risk free” so they aren’t supposed to discount any risk of default. More on that in a few minutes, though.
The steepness of the Treasury curve, defined here as the difference between 2 year and 10 year Treasury yields, is therefore an ongoing tug of war. On one side you have 11 people – the current size of the Federal Open Market Committee. On the other side is the open and highly liquid marketplace for government bonds. This struggle between closed-door policy and marketplace pricing is now at an important juncture. Consider the following (a 35 year chart of the 2-10 year spread follows immediately after the text):
- The difference between 10s and 2s swings from occasionally negative to a more normal state of 50 to 150 basis points positive (10 year rates higher those for 2 years). “Inverted curves” – where short-term rates exceed the yield on long dated bonds – occurred in the early and late 1980s, and again in the early 2000s. Exceptionally “steep curves,” when the difference between short and long end exceeds 250 basis points, are just about as rare, occurring in the early 1990s and again in the early 2000s.
- And of course, now. One key difference, however, between the today and the historical record is the current “stickiness” of a steep curve. Prior periods of 250 basis point differentials have been relatively fleeting affairs. The current spreads have been with us off and on – but mostly on – since 2009. That’s a result of the FOMC’s decision to leave short-term rates near zero for their “extended period” of time.
- The yield curve is usually an excellent indicator of future stock market returns. Those who say, “You can’t time the market” must not have bond prices on their quote screen. Since the 1990s if you simply bought when the yield curve was 250 basis points steep and sold when it “inverted” you would have be in stocks when the market rallied and safely out of equities when they got choppy. In for 1992 – early 2000 (one down year, and positive returns from 4-31%), and for 2003 – early 2007 (all up years with returns from 3-26%). Out for 1989 – 1991, missing all the volatility of the first Gulf War, and from 2007 – 2009. You know what happened then.
The current spread, at 290 basis points, is extremely unusual and demands separate analysis. Three points on the state of play today:
- There is solid economic reasoning for the “Yield Curve Indicator” as it relates to stock performance. This is not one of those market indicators, like hemlines or Super Bowl winning teams, which draws its strength from correlation rather than causation. Steep yield curves mean that the banking system has a powerful reason to lend more. Short-term money, in the form of what banks have to pay to retain deposits, is cheap. The return they get for lending that money over the longer term is much better, since the amount they can charge for loans like car notes or mortgages is higher. This encourages lending and loosens bankers’ cautious purse strings and spurs incremental demand. Economic growth ensues as easier credit spurs expansion. The increasing spread between the cost of money and the return from lending also helps bank profitability and allows them to rebuild capital bases damaged by recession.
- The positive feedback loop created by a steep yield curve sounds pretty compelling, so what’s the bearish case? There are several arguments, and they all essentially rest on the notion that “This time is different.”
First is the possibility that long-dated Treasuries are discounting inflation more than economic recovery. The Federal Reserve won a battle with inflation in the early 1980s, causing a long-term bull market in 10-30 year bonds. Now the Fed is actually trying to spark inflation - a very different dynamic. A strong dose of inflation, beyond the Fed’s ability to control it, would damage economic growth and give banks very little incentive to lend more, or produce little demand for capital from business managers. This would, of course, also drag down stock prices.
Second is the notion that the U.S. government is a less credit-worthy borrower than in past cycles. The country’s budget deficit runs +$1 trillion a year and total debt-to-GDP is essentially 1:1. The past two years have seen the U.S. issue a dollar of new debt for every dollar it collects in taxes. Substantial cutbacks in Federal spending seem unlikely in the run-up to a Presidential election in 2012 and in the absence of a Greece/Ireland-style capital markets crisis. In other words, long dated U.S. government paper may well need to offer greater yields to compensate investors for what effectively a lower quality product. A loss of the highest ratings on U.S. sovereign debt would raise the cost of borrowing, dampening economic growth and stock prices.
If you focus on the short end of the yield curve, another reason why a steep yield curve may not be especially predictive pops out from the data. The Fed’s desire to push savers to become investors and lift stock prices is materially different from the central bank’s traditional approach to prior recessions. That may mean that a steep yield curve is more the result of a policy shift that requires lower short rates for longer than is customary.
If a steep yield curve is meant to spark loan growth, it has yet to create this outcome. According to the Fed’s own data (see here: http://www.federalreserve.gov/releases/h8/current/) growth in loans and leases on bank balance sheets are still stuck in neutral. Bank credit of all types was down 5.6% in December 2010 from the prior year. For the month of January 2011 bank credit is essentially unchanged to December. Some loans considered to be leading indicators are up, however. Commercial and industrial loans, for example, were up 7.6% in December although January has not seen any further advance.
“When you hear hoof beats, think horses, not unicorns.” That old adage may well apply to the record steep yield curve. But the hoof beats at this point are distant. Like so many aspects of the current recovery, it may take more time than usual to see the results of a steep yield curve on lending and growth.