The yield curve right now is steep, which normally predicts recoveries, the logic being the long end rises on demand for corporate investment. Since we do not have any strong evidence of corporate borrowing for investment in growth – instead, corporations are sitting on record cash – this creates a conundrum that needs to be explained.
The yield curve short end is being held down artificially by the Fed. The last time this happened for a long duration was in the 1930s. The yield curve bent positive after 1929 and was positive for most of the time we were falling hard into the 1933 bottom – the Fed held the short rate down except during the sovereign debt crisis in 1931 when the Fed briefly raised short term rates to prevent gold flowing out of the US. Even as we came out of the bottom, we fell back down in 1938 when the yield curve was positive. Check out this chart from January 2007 when the curve ran negative (good timing!):
The Cleveland Fed put out a report on the yield curve recently concluding that a double dip is unlikely – but they are tracking experience post the Great Depression. Their dataset does not include any deflationary periods, and deflation changes the real rate on short-term instruments (it raises them – see analysis below). Since we are in the fourth credit collapse in US history (1837, 1873, 1929 and 2008), the best precedent would come from those prior eras, not the in-between times. Japan has had a positive yield curve for both of their lost decades of flat to down growth and continued deflation.
Also, the Cleveland Fed’s chirpy conclusion is belied by reports that the Fed is getting ever more worried about a double-dip. The Fed lowered GDP forecasts in their FOMC meeting on Wed.
The curve is flattening right now: The Fed holds the short term rates down, but now the mid term rates are dropping to record lows, and the longer term rates are lessening. Not a promising sign.
David Rosenberg argues the curve would be inverted right now if the Fed were not holding rates at essentially zero. A back-of-the-envelope calculation of the real yield curve shows it is inverted:
- the near-zero short rates less -3% deflation are running above 3% real
- the 4% long rates less a longer term modest inflation rate of 3% are near 1% real
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