Ten Year Yields: Higher or Lower?
But the savaging of fractional
reserve banking is only a small part of the message of Rothbard’s “America’s
Great Depression”. Contrary to the received wisdom that interventionist
government (under, Rothbard points out, the administration of Herbert Hoover
for some years before Roosevelt took the presidency) ameliorates and
foreshortens a dismal business depression, Rothbard suggests that the very
intervention so clamorously called for (both then and now) actually extends
and amplifies
it:
"I believe that banking institutions are more dangerous than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and the corporations that will grow up around the banks will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered."
Thomas Jefferson
Letter to the Secretary of the Treasury Albert Gallatin
(1802)
continued at FTThe Federal Reserve is working with the US Treasury on plans for a dramatic move into unsecured lending in the hope that this extreme step could help bring credit markets back to life.
As well as unsecured lending to banks, this could lead to the Fed directly purchasing commercial paper or funding a special purpose vehicle set up to do this.
| Investment Outlook |
| Bill Gross | September 2008 |
There's a Bull Market Somewhere?
A Depression-era bank robber
named Willie Sutton once said that the reason he robbed banks was
because “that’s where the money is.” Illegal for sure, but close to an
800 SAT score for logic if you were in the business of stealing other
people’s money. And now, while some will compare current government
bailouts to Slick Willie, citing moral hazard, near criminal regulatory
neglect, and further bailouts for Wall Street and the rich, common
sense can lead to no other conclusion: if we are to prevent a
continuing asset and debt liquidation of near historic proportions, we
will require policies that open up the balance sheet of the U.S.
Treasury – not only to Freddie and Fannie but to Mom and Pop on Main
Street U.S.A., via subsidized home loans issued by the FHA and other
government institutions. A 21st century housing-related version of the
RTC such as advocated by Larry Summers amongst others could be another
example of the government wallet or balance sheet that is required
during rare periods when the private sector is unable or unwilling to
step forward.
If inflation expectations have taken the prominent
This means that delaying
role in guiding future inflation, some difficult policy situations
could arise. It is generally expected that more slack in the labor
force should ease inflation. But Bernanke and Mishkin have argued that
inflation has become less responsive to the unemployment gap, while
inflation expectations have grown in importance. That means it may be
more difficult to lower inflation and inflation expectations once they
become elevated. If inflation is less responsive to labor slack, more
slack – that is, higher unemployment - will be needed to lower
inflation (the measure of this tradeoff is often referred to as the
sacrifice ratio).
convincing actions that would show that the Fed can contain price
levels would require a more severe response further down the road. A
credibly tough monetary policy would be a more manageable task if the
economy was recovering from a recession, instead of what looks like the
early stages of a contraction. Add in credit markets where
counter-party fear still dominates, an unemployment rate still rising,
and a presidential race looming, and the Fed seems to be left with few
effective responses
No, I have not lost my mind. I’m fully aware that inflation is not kind to bonds, so offering a kind word for inflation is de facto offering an unkind word about my own business. Investment managers don’t tend to do that. But facts are facts. And the essential fact right now is that the American economy needs an inflation rate above the Fed’s comfort zone. Needs, you ask?
Yes. Soaring commodity prices, particularly for petroleum and food, and especially in recent months, are an unambiguous negative real terms of trade shock to America. For those not familiar with the term, a nation’s terms of trade is the ratio of what it must give up to get what it imports. The easiest way to understand the concept, at least for me, is to think of the number of hours of work necessary, at the average national hourly pay rate, to buy a barrel of oil – a real variable compared to another real variable. The chart below (above here) tells that simple story.
Paul McCulley is an expert on the fed and always worth reading.
In Congressional testimony, Fed Chairman Bernanke spent most of his speech explaining what has happened in credit markets and why the Fed bailed out Bear Stearns. However, he also suggested that the worst for the economy is almost over.
Crossing the Rubicon
We believe that one of these unintended consequences will likely lead to the Federal Reserve becoming even more politicized. With the taxpayer’s purse being placed at greater risk by these governmental entities’ increased financial risk, the process by which the Federal Reserve conducts monetary policy may be placed in jeopardy. Will the Fed be as willing to raise interest rates to fight economic excesses or inflation if it means it could cause losses for these governmental entities or place the American mortgage borrower at increased financial risk? Given the extreme measures that are currently being contemplated, we believe this is a serious risk consideration. If we are willing to “rescue” borrowers and financial institutions that have been reckless or unwise in their financial decision making leading up to this crisis, how can we expect a different outcome in the future? Why should individuals and financial institutions conduct themselves in a financially prudent manner, knowing that the government will likely ride to their rescue? Why shouldn’t they take increased risk with the expectation of short-term gain, while laying off long-term risk to the government? The Federal Reserve’s recent policy changes, federal agency enhanced risk taking and possibly new consumer mortgage “rescue” plans, all have the potential of increasing future unsound business and consumer decision making.
The first -- and "easiest" -- mode is when investors refuse to buy at normal prices not because they know that economic fundamentals are suspect, but because they fear that others will panic, forcing everybody to sell at fire-sale prices.
_________________In the second mode, asset prices fall because investors recognize that they should never have been as high as they were, or that future productivity growth is likely to be lower and interest rates higher. Either way, current asset prices are no longer warranted.
This kind of crisis cannot be solved simply by ensuring that solvent borrowers can borrow, because the problem is that banks aren't solvent at prevailing interest rates. Banks are highly leveraged institutions with relatively small capital bases, so even a relatively small decline in the prices of assets that they or their borrowers hold can leave them unable to pay off depositors, no matter how long the liquidation process.
In this case, applying the Bagehot rule would be wrong.
The problem is not illiquidity but insolvency at prevailing interest rates. But if the central bank reduces interest rates and credibly commits to keeping them low in the future, asset prices will rise. Thus, low interest rates make the problem go away, while the Bagehot rule -- with its high lending rate for banks -- would make matters worse.
Delong contends, correctly I believe, that the Fed initially believed they had a type one problem but now are operating on the assumption they face a type 2 crisis. If the Fed should decide they have a type 3 problem it will have distinct implications for where one should be invested.The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall is larger. Easing monetary policy won't solve this kind of crisis, because even moderately lower interest rates cannot boost asset prices enough to restore the financial system to solvency.
When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out -- and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system in the long term, and even in the short term it is not very good. It is merely the best organization available.
The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.
I posted three somewhat bullish articles in a row so here is the other side.America’s economy risks mother of all meltdowns
Recently, Professor Roubini’s scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006*. At that time, his view was extremely controversial. It is so no longer. Now he states that there is “a rising probability of a ‘catastrophic’ financial and economic outcome”**. The characteristics of this scenario are, he argues: “A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe.The article goes on to spell out Professor Roubini's list of twelve steps to a very bad recession. I don't know if these things will happen (some have already) but they are all certainly possible. The most encouraging thing I can say is that people are talking about these risks now whereas a year ago such talk was dismissed out of hand.
A little pop up in the number of applications for refinancing finally. One of the first signs that the Fed's actions are getting a response.So, what’s unusual about the current yield curve?
- The slope of six months to three months (19 bp) is very inverted — a first percentile phenomenon.
- The slope of two years to three months (38 bp) is very inverted — a third percentile phenomenon.
- The slope of seven years to ten years is steep (57 bp - 5 bp away from the record wide) — a 100th percentile phenomenon.
- The slope of five years to thirty years is steep (186 bp - 30 bp away from the record wide) — a 100th percentile phenomenon.
- The slope of two years to thirty years is steep (274 bp - 97 bp away from the record wide) — a 97th percentile phenomenon.
- The slope of ten years to thirty years is steep (82 bp - 29 bp away from the record wide) — a 98th percentile phenomenon.
- The butterfly of three months to two years to thirty years is at the record wide (312 bp). (Sum of #5 and #2. Buy 3 months and 30-years, and double sell 2-years? Lots of positive carry, but the 30-year yield could steepen further versus the rest of the curve, and its price volatility is much higher than the shorter bonds.)
What prior yield curves is the current yield curve shaped like?
- 9/7/1993 — after the end of the 1990-1992 easing cycle to rescue the banks from their commercial real estate loans.
- 2/15/1996 — after the end of a minor easing cycle, recovering from the 1994 “annus horribilis” for bonds.
- 9/14/2001 — 60% through the massive easing cycle where Greenspan overshot Fed policy in an effort to reliquefy the economy, particularly industrial companies that were in trouble. Also days after 9/11, when the Fed promised whatever liquidity the market might need to stave off the crisis.
Okay, I’ve set the stage. What conclusions might we draw from the current shape of the yield curve?
Go to Aleph to read his conclusions. (I am only willing to pirate so much of his work)
