Here is a link to a 2006 Ben Bernanke speech suggesting that a flat or inverted yield curve may “be different this time” Bernanke Yield Curve Speech. This speech could have been delivered yesterday. We’re in the exact same scenario- solid GDP growth, low inflation, and a flattening yield curve. Then-Chairman Bernanke makes the argument that a lower term premium due to strong demand for longer term obligations (accompanied by the government’s and lenders’/investors’ expectations of low inflation and low interest rates in the future), caused by factors besides lenders’/investors’ expectations of slowing growth or recession, may be the cause of the yield curve’s flattening (the 10-yr. Treasury bond rate falling, as the 2-yr. Treasury rate rises)- as opposed to strong demand for the 10-yr. bond due to lenders’ expectations of both low inflation and a slowdown or recession. He also suggested that a global savings glut may be putting downward pressure on yields and was an additional reason to not fear a flattening or inversion as indicators of a forthcoming recession.
Any “it’s different this time” line of commentary about the yield curve is concerning, and, at least with regard to inversion, has usually (or always) proved to be wrong. How did 2007 turn-out, subsequent to this Bernanke speech? This economy is shaping up to be much like the 2005-2007 economy.
A business (and inflation) cycle is supposed to be: Demand growth from low interest rates, then job growth, then wage growth, then more demand growth, then prices rise, then interest rates rise and things cool down; and “not”: Liquidity rises, asset speculation rises, big companies use cheap money to get larger and larger and steal all the market share in their respective categories and put small businesses out of business- and kill the Phillips curve by controlling labor markets, wages stay stagnant (for consumers, who make up about 70% of GDP), gas prices rise because of the sheer volume of people working (with stagnant wages), houses become unaffordable due to excessive liquidity (including due to investors buying homes to rent out), debt grows because wages are stagnant, interest rates rise, even with little or no wage inflation (largely, to control asset bubbles), to exacerbate the problem, layoffs begin, due to oil and interest rates hitting businesses’s margins (with no ability by businesses to pass-through the costs to consumers, because of their stagnant wages), asset values drop, due to consumer debt overload, and the economy enters a deep recession or a near-depression requiring a government bailout. This latter scenario was what led-up to 2007 and 2008- results that could be repeated in 2019 (significant capex could push this out- though capex will most likely be used for buying and developing software programs and technologies that create and increase automation of internal business processes and the delivery of consumer services, and reduce needs for human labor).
We actually have had significant inflation for quite some time. Home prices are out of joint in relation to incomes and affordability- just as in 2005-2007. This is exactly the danger of inflation to a society- basic necessities, like shelter, becoming too costly. The yield curve may be speaking to this. Investors may believe that “it is exactly the same” this time.
Fed governors recently saying that U.S. bonds are now safe havens for foreign (and domestic) capital as emerging market (EM) volatility runs its course, and, therefore, the flattening curve is “different this time” is perplexing. Of course U.S. bonds are safe havens- that’s the point of bonds. The fleeing to them reflects investor sentiment about growth and inflation, and affects the curve. How is that any different than any other reason to buy bonds (beyond portfolio diversification)? The whole world is concerned about the whole world- so they buy U.S. bonds. It’s a signal. Otherwise foreign (and domestic) capital would go into U.S. stocks, rather than bonds and the dollar. Despite quantitative tightening and ever-increasing Treasury auctions- the curve is still flattening. Think about that. That is a lot of risk-off investment. That is a lot of fear. Fed governors should be cautious about dismissing this situation as merely transitory- or as irrelevant to the domestic economy. It’s a reflection of commercial and non-commercial investors’ sentiments about their own respective economies- which may be U.S. export customers. It also, of course, reflects investors’ expectations and fears about the U.S. economy, itself, and confidence that yields likely won’t significantly rise. Moreover, if the yield curve (or yield curves) inverts, for any reason, credit markets can seize-up. Finally, if international capital flows are, primarily, into shorter term Treasuries, then concerns by overseas investors about EM volatility would not be the cause of curve-flattening.
Keep the following facts and data points in mind when assessing the shape of today’s curve:
- The unemployment rate in October, 2006, was 4.4%- so, not much higher than today. Interest rates were rising, debt was accumulating, gas prices were elevated, housing prices were high, most inflation indicators were tame, wages were stagnant, the yield curve was flat, and analysts saw no end to growth in sight. Sound familiar? (And there was no trade war, as we have today.)
- Some days, the S&P is up only because oil and gas prices (i.e. energy stocks) are higher. Good for investors- bad for consumers.
- Real wage growth is lower when you factor in other inflation.
- Company earnings we see are for public companies. What about private businesses? What about their earnings? Home Depot and Amazon grow- while independent (and even chain) hardware stores and book stores across America close.
- Emerging markets are experiencing economic weakness and growing currency crises.
- Tariffs may lead to higher prices for consumers, while wages are stagnant and interest rates are rising.
- Global trade is slowing.
- Housing affordability in America is at its worst in nearly a decade.
- As housing slows, or crashes, from rising rates meeting stagnant wages, it, necessarily, means that construction jobs will decline.
- The worse single day point drop in Dow Jones Industrial Average history was this year- February 5, 2018. (It’s noteworthy, I think, that I published my article “The Yield Curve Speaketh: Why Stocks Might Crash In Early 2018” less than 60 days earlier.)
- 2018 second quarter GDP grew by 4.2%- but U.S. consumer debt rose in May, 2018, by the most in six months. Of course, the national debt keeps growing, too. Spending is easy- paying the bill is harder.
- In Bernanke’s 2006 speech, he discussed that more stable inflation, better-anchored inflation expectations, lower economic volatility, and a variety of other potential culprits that do not include investors’ expectations of slowing or negative economic growth, may be responsible for demand for longer term securities and the lower term premium that could be the reason for the flattening curve- an argument that is being reiterated- or recycled- by Fed Chairman Powell, some Federal Reserve governors, Goldman Sachs, and some analysts and portfolio managers, today.
- To suggest that curve flattening or inversion is an effect of a term premium that is reduced due to strong investor demand based on anything other than expectations of slow or negative growth (such as only being based on the government’s and investors’ better-anchored-inflation expectations, reduction in economic volatility, or pension fund needs) and, therefore, not predictive of recession, may be risky. In any event, studies show that if certain curves invert (the 10-yr.-3-month or the 10-yr.-2yr.), it is predictive of recession no matter what the cause of the lower term premium (most likely because an inversion, for any reason, impedes banks extending credit). Likewise goes for any dismissal of an inversion as being due to a global savings glut or a decline in the natural interest rate; such alternative explanations are fraught with perils if investors are, in fact, buying bonds with the expectations or fears of slowing growth, and policy fails to acknowledge and address such.
- A flattening or flat yield curve (as opposed to an inverted curve) does not, necessarily, portend recession. But, it is the overall and totality of circumstances (high corporate debt levels, a rising target Fed funds rate, rising consumer debt, elevated asset and gas prices, stagnant wages, lower than expected CPI, PPI, and consumer spending, and a growing national debt, etc.), and the similarities of today’s economy to the 2005-2007 period, that make a flattening curve feel like a precursor to an inversion, and, ultimately, recession (of equal magnitude to the one that began in 2007 and 2008). But, without an actual inversion, the historical value of inversions foreboding or causing recessions would, obviously, not apply. Mere flattening of an applicable curve, or an actually flat curve, is not enough for the predictive or causative nature of inversions to apply. In such a scenario, any steepening of the 10-yr.-3-month or the 10-yr.-2-yr. yield curves from here without ever having inverted, and any future economic growth, would not be haunted by a recession having been previously signaled (at least as far as the yield curves go).
- A flattening or flat curve is hardly a guaranty of recession in a year. An inverted curve may not even indicate a recession in anything less than 12 months. But, a recession need not be presaged by an inverted yield curve (though it most always is). Many problematic cyclical and/or structural problems, or a significant political or financial crisis, or exponentially growing Treasury sales on the longer ends of the curve to fund the growing national debt and deficit (which could affect the term premium) in the face of a slowing economy and declining GDP, could lead to recession without a preceding curve inversion.
- Commercial and non-commercial investors have no dearth of reasons to be moving capital into the U.S. bond market, especially where U.S. inflation is tame, including excessive housing prices in the U.S. as interest rates rise and wages stagnate, EM weakness and challenges to growth due to Fed tightening and tariffs, risks to EM lenders and to EM investors from such conditions, and the risk of contagion to the U.S. economy.
To determine (or speculate on) the reason for the shape of a yield curve (or for the change of the shape of a yield curve), one must first determine the cause of the shape (or the cause for the change of the shape) of that curve. For example, in the case of an inversion, in order to determine the reason for the inversion, one would need to know if the inversion is caused by Fed rate hikes or, rather, due to excessive buying of the 10-yr. bond- or by both.
Here’s a little poem I wrote:
If the the 10-yr.-3-month curve inverts,
or if the 10-yr.-2yr. curve inverts,
patient shorts will prove the warts-
and longs will lose their shirts.
About the Writer
Neil Siskind is: President of The Siskind Law Firm, focused on product investments, trademark licensing, product distribution, and real estate; Founder & Chairman of The Fatherhood Assignment™, a think tank and advocate for children with absentee fathers; Founder of the global charity marketing initiative, Caring is Free®; Founder of National Fatherhood Day™; Owner & Conservator of The Neil S. Siskind Nature Preserve, over 8 acres of conserved waterfront land along New York’s majestic Hudson River; and author of The Complete Guide To The Ways To Manufacture & Sell Your Products.On December 11, 2017, in his article The Yield Curve Speaketh: Why Stocks Might Crash in Early 2018, Neil Siskind successfully predicted the February, 2018 stock market crash, the largest single-day point drop in the Dow Jones Industrial Average’s history. If you are in need of office space in South Florida, contact Neil Siskind about space availability at The Siskind Executive Office Complex in Boca Raton, FL.
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