Posts filed under “Federal Reserve”

Explaining Yield Curve Inversions

The Yield Curve briefly inverted — twice — Monday. As we noted yesterday, the deeper and longer a curve remains inverted, the more potentially significant it is.

That factoid has been overlooked by many commentators. Following yesterday’s post about what an inversion means, it became
apparent that there is alot of confusion about the implications. So far, all we have is a brief inversion — which, for the moment, is merely a warning.

The best explanation I’ve read for what the Inverted Yield Curve may mean to the economy and markets comes from Lacy Hunt, a veteran Wall Street economist who formerly worked at the Dallas Fed:

"There has been a lot written about the flattening yield curve, though most people don’t understand what causes it.

The narrowing spread between yields is a superb leading indicator but shouldn’t be observed in a vacuum — no lone silver bullet can take down the economy. A steep flattening of the yield curve is a sign that the Fed is in the later stages of tightening its monetary-policy belt. It’s part of the broader process. But once it occurs, it does have its own implications for the economy and the markets.

Treasury yields should be viewed in concert with central-bank policy and changes in the availability of money and credit. The Fed influences supply and demand for money when it raises the fed-funds rate, since it pushes up money-market yields. To boost the funds rate, the Fed has to cut down on total reserves — money that banks are required to keep around for backing up deposits.

That reduces how much money can be supplied to people and businesses for borrowing and investing and it crunches the availability of credit that Americans now rely heavily on to keep up their spending habits. Banks’ profits, meanwhile, are crimped because they can’t make easy money by borrowing at low, shorter-term rates and lending at high, longer-term rates — one version of the time-honored carry trade. Higher rates can grind the borrowing and lending process to a halt — or it can reverse, where people pay their loans with money they normally would spend elsewhere. All told, economic growth is stunted.

The yield curve is flattening because Fed policy is working — it’s not a surprise that a higher fed-funds rate is followed by slowing growth in money supply and a narrowing in the spread between short- and long-term Treasury yields. This is clearly evident as 2005 draws to a close: Total reserves fell 4.1% in the past 12 months, and the contraction has happened at a faster pace in recent months because of the cumulative impact of 13 Fed rate increases. M2 money supply — cash, deposits and short-term assets such money-market funds — increased a paltry 3.4% in the last 12 months, the slowest growth in 10 years.

While the flattening yield curve is part of the process, it shouldn’t be taken lightly. This barometer narrowed significantly prior to all of the recessions since 1954, as well as two major business slowdowns in 1967 and 1995. In the middle of those slowdowns, the economy grew at annual rates of 1.6% and 0.9%, respectively. Only quick and decisive Fed action prevented worse conditions. Since 1954, growth in M2 when adjusted for inflation slowed dramatically in the four quarters right before recession. The same thing happened with the slowdowns of 1966 and 1995. That is why both the yield curve and M2 supply are widely considered excellent leading indicators.

Growth of less than 1% in real M2 in the past four quarters, combined with a sharp contraction in total bank reserves, reinforces what the yield curve is telling us: The economy is headed for a slowdown. That means either less inflation, less real growth, or some combination of the two."

I hope that’s not too wonky; it is as clear an explanation I’ve ever read, without dumbing it down too much. Note that the past 4 recessions were preceded by a Yield Curve Inversion, and prior flattenings have predicted a slowdown.

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Here’s a chart from today’s WSJ:
click for larger graphic

Wsj_20051227

chart courtesy of WSJ

UPDATE:   December 31, 2005  5:13am

A reader asked for a study on inversions and recessions. Marketwatch reported that Merrill Lynch just released a study (on Friday!) on the subject: 

"The historical record speaks for itself," said Merrill Lynch analysts in a report published Friday.

"In the past 30 years, the yield curve has inverted five out of the
eight times the Fed has been tightening monetary policy. Each of those
five times an economic recession has ensued one year later — our fear
(though not our base case) is that this time will be no different."

If anyone has access to this, please contact me about  sending it.


 

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Sources:

Examining an Inversion
TRADING SHOTS
WSJ, December 23, 2005
http://online.wsj.com/article/SB113528182051629707.html

Yields on Bonds Invert, Reflecting Unease About Economy’s Future
MARK WHITEHOUSE
THE WALL STREET JOURNAL, December 28, 2005; Page A1
http://online.wsj.com/article/SB113569973698732182.html

Stocks could see rebound on data
Economic data and 4Q earnings to greet the New Year
Jasmina Kelemen
MarketWatch, 5:01 AM ET Dec. 31, 2005
http://tinyurl.com/849qk

Category: Economy, Federal Reserve, Fixed Income/Interest Rates, Inflation

Inverted Yield Curve: Its different this time (not)

Category: Federal Reserve, Fixed Income/Interest Rates, Inflation, Technical Analysis

Federal Reserve Chairman George Costanza

Category: Federal Reserve

Economists React to Fed

WSJ 

The Federal Reserve, as expected raised interest rates for the
13th consecutive time Tuesday, lifting the federal-funds rate by a quarter
percentage point to 4.25%. The central bank suggested it would raise rates
again, but also hinted that it is less certain on its future rate actions than
it has been in over a year. In the accompanying statement, the Fed said growth
remained "solid", inflation excluding food and energy prices had "stayed
relatively low," and inflation expectations were contained. But it also warned
that the possibility of further erosion of spare productive capacity and high
energy prices "have the potential to add to inflation pressures."

What do
economists and other analysts make of the changes? Here’s a sample of their
commentary:

* * *

The Fed has finally taken the step that we have been
pointing to for a while, in separating the two concepts of reaching neutrality
and finishing the rate cycle. They kept "measured," as we thought they might,
but now it refers to "some further measured policy firming" as opposed to
removing accommodation at a measured rate. So, rather than being on automatic
pilot in raising rates toward neutral, the FOMC now sees itself in the second
stage of the rate hike cycle — further moves will be perceived by Fed officials
as taking policy toward a restrictive stance.

– Stephen Stanley, RBS
Greenwich Capital

* * *

The message from the FOMC appears to be that barring a
major change in the tone of economic data, another 25bp tightening move will be
implemented at Chairman Greenspan’s last meeting on January 31. At that time, it
is quite possible that the "measured phrase" will be jettisoned, leaving
incoming Chairman Ben Bernanke with a clean slate for the next meeting on March
28. Our own view remains that the evidence concerning economic growth should be
sufficiently strong in coming months to spur another three 25bp tightening
moves, lifting the Fed funds target to 5.00% in the second quarter of the year.
We think that growth will then be moderating sufficiently for the FOMC to cease
tightening, even if core inflation drifts up mildly from its current
levels.

– Joshua Shapiro, Maria Fiorini Ramirez Inc.

* * *

The Fed announced: "Core inflation has stayed relatively
low in recent months and longer-term inflation expectations remain contained."
Quite frankly, we do not believe them. We know that beyond the rises in food and
energy prices, nearly everything — from healthcare to building materials to
education costs to insurance to commodities — costs more. And gold, the world’s
best inflation indicator, is well over $500 per ounce. Where ever we look, we
see evidence that prices have limited stability and an upward bias.


Barry Ritholtz, Maxim Group

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