Real long term interest rates and recessions

- by New Deal democrat

One Salient Oversight is a kindred blogger who also dissects historical patterns of economic expansion and contraction. He tracks three series, two of which are virtually identical to the "Kasriel Recession Warning Indicator." Based on those, he believes that a recession will start between Q4 of this year and Q4 of next year.

Like Kasriel, he relies upon the yield curve (inverted vs. positive), and real inflation-adjusted money supply (except he uses real monetary base vs. Kasriel's real M1).

His third indicator is real long term interest rates. Specifically, whether 10 year treasuries are yielding more or less than the inflation rate. It is specifically this indicator which has, according to his model, turned negative, presaging a recession. Here's his graph showing the real 10 year treasury yields for the last several years, showing it has been below the rate of inflation for the last 3 months:



One Salient Oversight's point is that a negative real long term interest rate doesn't always occur before a recession, but rather since 1954, whenever the rate does turn negative, a recession has always followed. You can see his in-depth graphic parsing of this indicator here.

To better look at this relationship, I have broken the relationship down to its two component parts. Here are 10 year treasury rates vs. inflation from 1964 to 1987:



and here is the continuation from 1987 to the present:



One Salient Oversight is indeed correct that during this time, whenever the inflation rate has exceeded the yield in 10 year treasuries, a recession has followed.

But what about before 1954? The "great recession" and its aftermath appear more like pre-WW2 recesions than postwar inflationary recessions brought about by Federal Reserve tightening. Since 10 year treasury data only goes back to the early 1950s, to go back further, you need a proxy that yields the same or similar results.

Indeed, such a proxy exists, in the form of the series LTGOVTBD (long term government bonds) that runs from 1925 to 2000.

First of all, here is the same relationship using LTGOVTBD over the post 1954 era and it almost exactly tracks the 10 year bond series, and makes the same predictions, so we know it is a good proxy:



But here is the problem: from the great depression until 1954, you get almost the exact OPPOSITE result as in the more modern era. Negative real long term rates occur during most of the New Deal, WW2, and immediate post-war era. In fact, they are at their trough at about mid-expansion. And these were the biggest expansions of the entire 20th century:




If we believe that our current situation is more akin to the pre-WW2 situation, negative real interest rates are of no help at all.

Nevertheless I think One Salient Oversight is on to something, especially as ECRI has vehemently denied that an inverted yield curve is part of their analysis, but appears to acknowledge that bonds are a component of their "black box." One big difference is that in the post WW-2 inflationary recessions where the indicator works, bond yields as well as inflation have both spiked higher compared with their 2-5 year average. By contrast, in the New Deal, WW2, and immediate post-war era, interest yields did not spike at all compared with inflation.

The need for wage-improving, Demand-Side Economics

- by New Deal democrat

From Bonddad: This is, without a doubt, one of the best pieces NDD has ever written. I agree 100% with his conclusions on the topic. While I'll be posting on this topic something later this week, NDD has provided a far more thorough and well-researched article.

There has been a secular shift in the American economy going back at least 4 years. The self-congratulatory "great moderation" was really the reflection of wage stagnation for the majority of Americans being masked by increased household debt loads, and the ability to carry those increased debt loads due to the ability to refinance them at lower and lower interest rates.

This secular shift is a phenomenon I first wrote about at great length in 2007, asking Are Hard Times Near? That pessimistic prediction has been answered in a thunderclap-like affirmative ever since. I have returned to this issue several times during the last four years, writing last year under similar circumstances to our present slowdown that wage stagnation was the greatest threat to the recovery.

Simply put, when there is only 1-2% wage growth per year, any inflationary spike - even a 3% spike due to energy increases - is enough to cause the economy to stall. There can be no long-term, sustained recovery for the large majority of Americans unless there is real, long-term wage growth. Thus, while at one level the current slowdown or stall is the result of an energy price shock, on another level it was predictable (and predicted by others and me) due to prices faced by consumers rising faster than their disposable incomes.

In summary, American consumers:
* have not had an increase in household wealth
* have been unable to refinance at lower interest rates for more than 3 years
* have been unable to tap into increased wealth via stock or house price appreciation above previous levels
* and have chosen instead to cut back significantly on debt (more than 1/2%)

only three times in the last 31 years: during the recessions of 1981-2, 1990-1, and the "great recession" of 2008-09.

This result can be easily seen by showing real, inflation-adjusted YoY hourly wages, and also the effect of declining vs. stalling interest rates.

Before looking at the graphs showing those long-term trends up until now, first let me show you what I said back in August 2007 on the cusp of the "great recession":

The American consumer has had largely stagnant wages since 1974.... [F]rom 1980 through 2006, the median income of an American household has risen only from $39,700 to $48,200 in real terms .... Consumers have responded generally by taking on more and more debt. Total household debt service has risen from 16% in 1980 to 19.4% in 2006.

Fortunately for consumers, there has been a generation-long decline in interest rates since they peaked at 15.21% for the 30 year US Treasury bond in October 1981. This has allowed consumers to refinance their debts at ever lower rates every few years. They have also been assisted by a bull market in stocks that took the S & P 500 from 102 in 1982 to 1553 in 2000, and the subsequent housing boom/bubble.

There are signs that this "Great Disinflation" of declining interest rates is coming to an end. Only twice in the last 27 years has the consumer been unable to refinance debt or tap into his or her stock or house ATM.... [T]he 3rd and final time is almost certainly near.

.... If consumers are unable to tap the value of assets, or to refinance, then without improvements in wages, they will pull back and cause a consumer-led recession. Since 1980, this has only happened twice: in the deep Reagan recession of 1981-82, and again briefly from July 1990 to March 1991.

.... [T]he failure of interest rates to make new lows signifies that any continued deterioration in house prices, or significant and sustained decrease in stock prices, will likely give rise to an imminent recession danger sign.

The YoY% change in real, inflation adjusted hourly earnings for the last 30 years is shown in this graph:



With the exception of the late 1990's tech boom, and those times in the last 10 years when energy prices briefly reversed, real hourly income has made no progress at all. The 1981-82, 1990, and 2008-09 recessions have all been accompanied by declines in real hourly income.

Now, let's show how mortgage rates have behaved since peaking in the early 1980's:



Notice that there has been a general 30 year long decline in rates, punctuated by stagnant rates in the late 1980s, most of the 1990s, and the housing bubble era.

Here is a slighly different look, showing the year-over-year change in mortgage rates:



Now, let's put the two series together, showing real YoY% wage changes in blue, and YoY changes in mortgage rates in red:



This graph shows that stagnant or rising mortgage rates occurred at the same time as stagnant or declining real incomes (generally, when the red line is higher than the blue line in the graph above) during mid-cycle slowdowns at on the eve of or start of the post-1980 recessions. This was true by the end of 2007, it was true in last summer, and it has been true for the last few months.

Thus, only one month after the story quoted above, in September 2007, with new data showing that households were beginning to shun debt, it seemed clear that under the above criteria, consumers were signalling recession:

In order to avoid a recession, house price declines must stop, stock market gains must accelerate, or household income must increase significantly. Failing at least one these three things, if households have continued to cut back on debt, as appears likely, America will probably enter (or may already have entered) only its 3rd consumer recession since 1980.

This was the final shoe to drop. Household debt deleveraging in the face of stagnant wages and the inability to refinance has been the harbinger of all post-1980 recessions. Here is how household deleveraging stands as of the last report (4Q 2010):

I revisited the issue of real wage growth as a necessity for sustained economic growth in May 2009 even as I foresaw the bottoming of the recession:

the indicators studied from the Deflationary period of 1920-1950 suggest that the GDP might stop contracting in about Q3 2009, and start to actually grow.

But then what?

Whether the bottom of the trough of this decline in economic activity is in a few months, or if it is a year or two or more away, the fact remains that, with anemic wage growth to say the least, any incipient recovery ... would be short lived, strangled by the inflation caused by its own increase in demand. If the inflation rate agains exceeds wage growth, consumers will simply cut back again, plunging the economy into another leg down of a "W"-shaped recession.

.... In summary, from here on ... we're not going to see any sustained recovery in the American economy until average Americans see a real and sustained increase in their compensation for labor -- for the first time in over 35 years.

But there is still one more chance ... [i]f long term interest rates do decline again, consumers may yet have one more chance to refinance their spending for the next few years.

.... While if lower mortgage rates persist, there will be space for an economic breather, the paradigm of my 2007 piece remains true. So long as real wages remain stagnant, any recovery which might start will be vulnerable to every uptick in inflation and interest rates, and will be shallow, weak, and probably short-lived. The Great Disinflation of Interest Rates is Ending, the long-term structural problems of our economy have become immediate problems as well, and no long-term recovery is going to take root without real wage growth.

Luckily, as shown in the first graph of 30 year mortgages shown above, consumers did indeed get yet one more chance to refinance in 2010. But the problem with stagnating real wages surfaced again during the summer slowdown last year:

[T]he economic recovery is in a very tight spot -- precisely because average American consumers also remain in a very tight spot. [There has been] wage growth of about 1.5% for the last year. Under those circumstances, even 2% inflation is too much for them to withstand -- without the ability to refinance debt, their disposable income simply isn't keeping up....

So with paltry income increases of about 1.5%, there are only two ways to sustain the recovery for very long: (1) the inflation rate remains in a very narrow window of 0-1.5%; (2) some asset held widely by average consumers appreciates in value. or (3) another opportunity arises to refinance mortgage debt.

I thik we can all agree that number (2) doesn't look like it's going to happen. That leaves either number (1) or number (3).

....The price of Oil in particular will determine if inflation can remain in the "sweet spot" necessary given low wage growth

.... [O]nly a very narrow window of inflation is helpful to the recovery, and if the unlikely event of decent wage increases doesn't happen, that kind of extremely tame inflation is dependent most of all on energy prices....

This is a very small needle to thread - so the biggest danger to sustaining the recovery.

I have quoted my earlier material at length to show you that this isn't some new theory. I've been writing about it since before the "great recession" and indeed predicted both the beginning and bottom of the recession in large part based on this paradigm. It has proven itself empirically in the real world.

When interest rates fall to new lows, consumers respond aggressively by refinancing debt, freeing up more spending power. When that isn't available, and when households can't cash in on rising asset prices (e.g.,houses or stocks) even inflation of only 2% can be enough in the face of stagnant real wages to choke off any real increase in consumer spending and the economy stalls - or worse.

Aside from the need to prevent repeated energy price shocks throwing the country into recessions, among the most pressing priorities is the need to replace "supply side" economics with "demand side" economics that tilt the scales in favor of real, sustained wage increases for average Americans. Without that, there can be no long-term strong recovery or expansion.

Federal Debt Could Constrain Obama's Plans

From the WSJ:

The Treasury Department laid out near-term borrowing plans Wednesday, saying it expects to tap financial markets for $550 billion in the final three months of 2008 and another $368 billion in the first three months of next year by issuing Treasury securities with a wide range of maturities.

Economists project that total government borrowing could pass $1.5 trillion in the fiscal year, which ends next September, pushing up the government's total debt burden by more than 25% in one year.

.....

The sharp rise poses a potential dilemma for Mr. Obama's ambitious agenda. Few economists believe the Treasury will be constrained in the next year in its ability to manage its rising borrowing needs or in advancing another fiscal stimulus program. But in the long run, rising government debt could make it harder for Mr. Obama to pursue new spending and tax-cut programs aggressively.

"I don't think that anything on the stimulus end will be constrained by these deficits," said David Greenlaw, a Morgan Stanley economist. "But if you're talking about health-care reform and some of these longer-term programs, there is some constraint there."

Let's get some political baggage out of the way before we go forward.

I've been complaining about the deficit for the last 4 years. And I will continue to complain about the deficit for one primary reason: as a country we have to make choices. Some things are more important than others. Those things we find important we should spend more money on.

Over the last 8 years we have not made any choices. Instead we have funded, well, everything that has come down the pike. In addition, we cut taxes, further exacerbating the problem of deficit financing. As a result, we have issued mammoth amounts of public and intra-government debt. Here's a reading of the last 8 years from the Bureau of Public Debt:

09/30/2008 $10,024,724,896,912.49
09/30/2007 $9,007,653,372,262.48
09/30/2006 $8,506,973,899,215.23
09/30/2005 $7,932,709,661,723.50
09/30/2004 $7,379,052,696,330.32
09/30/2003 $6,783,231,062,743.62
09/30/2002 $6,228,235,965,597.16
09/30/2001 $5,807,463,412,200.06
09/30/2000 $5,674,178,209,886.86

The current total is $10,566,146,196,490.58

From a debt as a percent of GDP perspective we have increase from 57% in 2001 to 73% at current levels. Now -- it's entirely possible for the US to issue more debt. I would become extremely concerned at the 85% and higher level. That means we have some way to go. But there are other problems involved with that development.

1.) Interest rates. Here is a chart of the 10 year CMT's interest rate for the last nearly 40 years.



Click for a larger image

Clearly rates have been heading lower. Will the issuance of all this debt finally break this cycle? Will the US finally start having to pay for a higher rate of interest to attract purchasers?

2.) The dollar. While the dollar has enjoyed a rally recently more debt could kill that pretty quickly.



Click for a larger image

While a drop in the dollar would be great for exports it would also be stoking commodity based inflation because most of the world's commodities are priced in --- dollars.

In other words -- there are a lot of policy angles we need to consider going forward.

Rate Cuts Aren't the Answer

I've strenuously argued against cutting interest rates for awhile now. There are several reasons for this.

1.) Even before the Fed started lowering interest rates, overall interest rates were not that high.

2.) Inflation is a bigger problem than the Fed thinks.

3.) Lower rates won't do squat about financial firms wrecked balance sheets.

Now we're learning that lower rates don't mean, well, lower rates..

Mortgage applications fell 22.6% in the week ended Feb. 15, the Mortgage Bankers Association said. That's the lowest since the week ended Jan. 4.

The 30-year fixed mortgage rate soared 37 basis points to 6.09%, the highest since late December. It's continued to surge this week.

Longer-term mortgage rates are closely tied to the 10-year Treasury yield, which has roared back in part due to inflation concerns. The benchmark yield was unchanged at 3.90% on Wednesday.

Refinancing activity, which skyrocketed as Treasury yields and mortgage rates dived in January, is coming back to earth.

Applications for buying a home fell to their lowest level in nearly five years.

The article goes on to state:

Economists expect that slowing growth will naturally cool inflation. GDP advanced at just a 0.6% annual pace in the fourth quarter. Some analysts are predicting a mild recession in the first half of this year as job growth and consumer spending slow.

I don't see that until we see major economic cooling from China and India.

Interest Rates Aren't That High

With all the talk of the rate cut you'd think that interest rates were currently at restrictive levels. That's simply not the case. Here are a few charts from the St. Louis Federal Reserve that show interest rates are pretty low by historical standards:

10-Year Treasury



AAA Seasoned Corporate Papar



BBB Seasoned Corporate Paprt



30-Year Conventional Mortgage



Prime Lending Rate



In other words, the current cost of money is far from restrictive. That means the problems in the economy are probably not driven by money being too expensive, but one of confidence. Lenders are still concerned about borrowers ability to pay back a loan even over a short time period. Lower rates won't solve that problem: there is still a ton a bad debt in the system.

Did Ben Think About This?

One of the primary reasons I was (and am) against the rate cut is the impact on the US dollar. The markets are currently playing out that scenario.

The Fed's move put more pressure on the dollar because it made returns on investment in other countries more valuable. The weak dollar also means that American goods are cheaper for overseas buyers, which can help manufacturing and producers, and can help companies with big foreign operations turn a larger profit by converting overseas profit into dollars.

But it also could scare away foreign investors who help to finance the U.S.'s debt. As investment in U.S. Treasury securities dwindles, the government will have to pay higher rates at weekly auctions to find buyers for its bills, notes and bonds. That eventually could push up borrowing costs for all Americans.

Here is a chart from the St. Louis Federal Reserve that shows how dependent the US economy is on foreigners purchasing US government debt:



My guess is this will add further long-term upward pressure on interest rates.

Commercial Paper Market Still Shrinking

From Bloomberg:

The U.S. commercial paper market shrank for a third week, extending the biggest slump in at least seven years, as investors balked at buying short-term debt backed by mortgage assets.

Asset-backed commercial paper, which accounted for half the market, tumbled $59.4 billion to $998 billion in the week ended yesterday, the lowest since December, according to the Federal Reserve. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion.

Commercial paper outstanding has fallen $244.1 billion, or 11 percent, in the past three weeks, suggesting the Fed's Aug. 17 reduction in the discount rate has yet to entice buyers back into the market. More than 20 companies and funds including Cheyne Finance and Thornburg Mortgage Co. failed to sell new paper as investors fled to safer investments.

``I don't think the Fed understands how critical the situation is,'' said Neal Neilinger, co-founder of NSM Capital Management in Greenwich, Connecticut, in an interview today. ``The market is going to overshoot itself and not lend money to people who deserve it.''

....

Commercial paper is bought by money market funds and mutual funds that invest in short-term debt securities. In asset-backed commercial paper, the cash is used to buy mortgages, bonds, credit card and trade receivables, as well as car loans. Some of the programs are backed by subprime loans. Subprime loans are issued to borrowers with poor credit or high debt.

About 26 percent of asset-backed commercial paper outstanding as of July was used to fund purchases of mortgage- related securities, according to Standard & Poor's. The yield on the highest rated asset-backed paper due in a month reached a six-year high today of 6.18 percent.

Over the last few weeks PIMCOs Bill Gross wrote an article where he basically argued the central problem faced in the markets right now is no one knows where the next problem will pop-up (I believe he used the "where's Waldo" analogy). That perception is starting to bite the markets because no one wants to buy a land mine. As a result, most people are simply shying away from the market altogether.

However, there is no guarantee a rate cut would change this situation. The problem is not about the cost of money. The problem is what will people do with the money. Just because someone has money to spend, it does not mean they are going to spend it on what the market wants them to spend it on. And as recent experience in the T-Bill market shows, people are looking for safety right now. Lowering the fed funds rate will only make that situation worse.

What we have right now is a problem with asset quality and the perception of asset quality. And that won't go away by making it cheaper to buy assets.

Interest Rates, Corporate Profits and Economic Growth

This paragraph from a WSJ article got me thinking:

Tom Sowanick, chief investment officer for investment manager Clearbrook Financial LLC's Clearbrook Research unit, says concerns that rising rates will hurt corporate stocks may be overblown. He notes that since its June 2003 trough, the yield on the 10-year Treasury note has climbed two percentage points, and the yield on the two-year note has risen nearly four percentage points. During the same period, he says, the S&P 500 has risen 64%, while the Russell 2000 Index, a measure of small-stock performance, is up 95%.

Let's look at a few points.

1.) US interest rates are rising from generational lows. Here is a chart of the effective Federal Funds rate. Notice it is rising from the lowest levels of a generation.



So -- while interest rates are increasing, it's important to remember where they're rising from: the lowest rates we'll see in our lifetime.

2.) The 1, 5 and 10 year constantly maturing Treasury Bonds have all been rising for the last few years with no impact on corporate profits.

1-Year Treasury



5-Year Treasury



10-Year Treasury



I've added a few more points to the 10-year chart. First, notice current yields are just now approaching and broaching the lowest levels of the preceding expansion's interest rate levels. In the 1990s expansion corporate profits grew just fine. So some of the concern may be overblown.

In addition, most companies have very strong balance sheets and have already locked-in lower borrowing costs:

There are several reasons the initial shock over higher Treasury yields has quickly worn off. For starters, most corporate debt is locked in for the long term, and won't roll over for years -- as long as a decade for some companies with investment-grade bonds outstanding.

At the same time, many companies are so flush with cash after several years of booming profits that increased borrowing costs won't make a big difference at this point. Excluding financial companies, components of the broad Standard & Poor's 500-stock index have enough cash on hand to buy back 40% of their outstanding long-term debt, S&P says.

However, notice that 10-year rates are clearly increasing and will probably maintain that course for the foreseeable future. In other words, the rising rate story will probably be with us for the remainder of this expansion.

Most of the interest rate stories over the last few weeks have an implied premise: there is an inflection point in interest rate levels above which rising rates have an increasingly negative impact on corporate growth. I think this is more of a sliding scale, where an increasing level of rates by x% will lower corporate profits by y% or something to that effect. In addition, I don't think current interest rate levels are so high as to inhibit profit growth. The main factor causing slower profit growth is a slowing US economy, not higher interest rates.

It's a Small World After All

For the rest of the day you will be cursing Bonddad for putting that damn song in your head.

From the WSJ:

The jump in yields has been driven by strong economic growth and rising inflation outside the U.S., which has prompted central bankers in Europe, Japan and elsewhere to raise, or consider raising, rates. Last week, the European Central Bank increased its target interest rate to 4% from 3.75% and signaled that there are more rate increases to come. The Bank of England and the Bank of Canada are expected to raise rates next month, and the Bank of Japan looks poised to raise rates later this year.

That U.S. bond yields have jumped despite weak U.S. economic growth is further evidence of how interconnected the world's markets have become. Increasingly, the U.S. market is being influenced by global investors. That's in part because the U.S. imports far more than it exports to countries like China and makes up the difference by borrowing from foreigners, who have been flocking to U.S. bonds. To continue attracting those investors, U.S. bond yields need to compete with rising yields abroad.

And from Bloomberg:

European government bonds slid by the most in more than a year on concern quickening global expansion will prompt central banks to increase interest rates.

The slump sent 10-year bund yields to the highest since August 2002 as traders raised bets the European Central Bank will lift rates twice more in 2007 and as ECB official Erkki Liikanen said the outlook for growth in the region will stay positive. Bunds followed Treasuries lower after former Federal Reserve Chairman Alan Greenspan forecast rising yields and greater premiums on emerging-market debt.

``There's been a reassessment of global interest-rate expectations, which is hurting bonds,'' said Stuart Thomson, who manages 23 billion pounds ($45.5 billion) in bonds at Resolution Investment Management Ltd. in Glasgow, Scotland. ``The market is being driven down by a capitulation of long positions.'' A long position is a bet an asset price will rise.

The International Monetary Fund's World Economic Outlook highlighted the possibility of higher global growth outside of the US this year. This is where the rate pressure is coming from. Higher growth = higher demand = possible higher inflation.

Bond Yields Hit 5-Year High

From the WSJ:

U.S. bond yields hit a five-year high, with the yield on the benchmark 10-year Treasury note rising to nearly 5.25%, driving up the cost of everything from $150,000 home mortgages to $20 billion leveraged buyouts and threatening to slow the nation's economic growth.

Investors continued to dump Treasurys yesterday -- as they have for more than a week -- amid worries about rising inflation abroad and concerns that foreigners might curb their purchases of U.S. bonds, which have been an important source of support for the market.

......

Rising interest rates raise the monthly payments of homeowners with adjustable-rate mortgages and make it more costly for them to refinance to a fixed rate. They could also put the brakes on the corporate buyout boom, which has been financed by cheap debt and has helped to drive the stock market higher in recent years.

Yesterday, the 10-year note closed at 5.249%, just above last year's peak rate and slightly below the recent high set in May 2002 of 5.259%. The note's price, which moves in the opposite direction of the yield, was 94 8/32, down 27/32, or $8.4375 for each $1,000 invested. The price of the 30-year bond was 91 1/32, down 1 20/32, pushing its yield up to 5.356%, the highest since June 2004.

In less than four weeks, the yield on the 10-year note has climbed from just 4.7%, a huge jump for bond yields. In the past, such sharp moves have led to big losses for hedge funds and other investors who rely heavily on borrowed funds.

There's a lot here to take in.

1.) I don't see this as a huge problem for the buy-out boom. I wouldn't worry about that until yields hit 5.75% or so.

2.) However, the mortgage implications are huge. Credit standards have already tightened. At a time when inventories are at absolute all-time time highs we now have the market naturally slowing demand. I'm sure the mortgage banking industry is cursing this development.

3.) There's been a lot of talk about inflation lately. So, let's take a look at the official BLS inflation numbers. Here's a chart of the Y/Y percent change in the overall inflation level including food and energy.



There was a big run-up from 2004 to early/mid 2006, but then there was a drop thanks to a drop in oil prices. However, it looks like the Y/Y change is once again moving up which should give us reasons for concern.

Here's a chart of the Y/Y percent change in core inflation:



Remember that with this chart the Fed is trying to see if higher food and energy prices are bleeding over into other areas of the economy.

The Fed has an unofficial target of 1%-2%, so we're above the Fed's comfort zone here. Also note this number has been coming down since about mid-2006. The Fed has been stating that inflation should moderate as the economy slows and it appears this has in fact been happening. While the core rate is above what the Fed wants, it's still manageable.

Here's the Y/Y percent change chart of food prices:



Corn is an important base element in the US food industry. It's used as a raw material (DUH!) but also as a feed stock for livestock. Let's call this the "ethanol chart", because what we're seeing here is the effects of the national ethanol policy. As the number of uses of corn has increased we have not seen a proportionate increase in the supply of corn. When demand increases faster than supply, prices increase. This is what we're seeing now.

Here's the Y/Y percent change in energy prices.



Notice the big dip last year when Goldman Sachs lowered the percentage of gasoline in their energy index. However, we're once again seeing this number increase.

The financial press has done a disservice to the investing public by focusing a bit too much on the core number and not enough on the overall number. While that number is OK, it could be better. And that is what investors are concerned about right now from the inflation front.

Managers Lower Treasury Exposure

From Bloomberg:

The biggest rout in the Treasury bond market in three years is making Wall Street's bond bulls more bearish.

Investors are ``throwing in the towel,'' said Robert Auwaerter, who oversees about $350 billion as head of fixed- income investments at Vanguard Group in Malvern, Pennsylvania.

Fourteen of the 21 banks and securities firms that underwrite the government's debt changed their outlooks for lower interest rates or increased forecasts for bond yields last week. Fund managers who oversee $1.34 trillion said Treasury and agency securities fell to 26 percent of their holdings from 36 percent as of May 18, according to a survey by Ried Thunberg & Co., a Jersey City, New Jersey-based research firm.

The combination of U.S. government reports showing rising labor costs and lower worker productivity with a surprise increase in New Zealand rates triggered the biggest one-day rise in 10-year Treasury yields since May 7, 2004. Even Goldman Sachs Group Inc. and Merrill Lynch & Co., which predicted the Federal Reserve would reduce its target rate for overnight loans between banks this year, abandoned their forecasts.

``Momentum could be toward even higher yields in the next couple weeks,'' said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG's Private Wealth Management unit in New York. ``If rates rise overseas, they will become competitive for the U.S. and therefore rates here have to rise.''

A majority of the big trading firms are now a bit more bearish on bonds. They have decreased their holdings pretty substantially within the last month. That means there is less upward pressure on bond prices. It also partially explains the recent increase in yield -- fund manager liquidation.

If these managers continue to liquidate, expect yields to increase.

Nice Summation On Interest Rates

From the WSJ:

Rising rates make it harder for buyout firms to finance takeovers with borrowed money, and buyouts were one of the main supports for stock prices. Higher rates make bonds more attractive alternatives for big institutions such as pension funds. They make it more expensive for businesses and consumers to invest and to buy things, which hurts corporate profits. And higher rates make dividend-paying stocks less attractive compared with bonds.

Beautifully written.

Fed's Lacker Is Concerned About Inflation

From CNBC:

However, Lacker, one of the Fed's toughest inflation hawks, said he'd like to see the inflation rate come down a bit more. Although he is not a voting member of the Fed this year, Lacker dissented four times last year from the majority at the Fed who wanted to keep interest rates unchanged instead of raising them.

“I don’t think the moderation we’ve seen is statistically significant,” he said. “The core inflation has been fluctuating between 2% and 2.5% for two years now and before that from 1996 through 2003, core inflation was between 1% and 2%. We need to get back to containing core inflation between 1% and 2%.”

I have to admit, the following statement made me laugh.

Still, the Fed official believes the economy and consumers can handle higher gasoline prices. He said his major concern is that the public has become “conditioned” to the idea that higher oil and gasoline prices equal higher inflation.

“That does not have to be true," he said. "It is a matter of relative price changes that go on all the time in a healthy economy. Lacker said he was worried that rising gasoline prices will prompt an uptick in inflation expectations.

Obviously, Lacker wasn't aware that Wal-Mart had a big sales decline recently, which they attributed in part to higher gas prices.

In addition, the average consumer probably isn't thinking relative prices when they fill up at the pump. What they are thinking about is "this is getting pretty expensive."


Any questions? I've been adamant in my stance that the Fed won't lower interest rates anytime soon. While the economy is growing below it's full potential, the inflation rate is still higher than the Fed wants it to be. As a result, don't expect a rate cut anytime soon.

Fed's Moscow Wants Lower Inflation

From Reuters:

Moskow noted that core inflation is still running above the 1 percent to 2 percent range that some policy-makers, including himself, see as an informal comfort zone.

"I'd like to see inflation rates running lower at this point and more toward the center of that zone," he said.

This was brought to you by the guy who has been saying for the last 6-9 months the Fed isn't going to lower rates anytime soon.

European Inflation Still Around

From the WSJ:

Euro-zone inflation risks "have not diminished" in recent months and the European Central Bank hasn't signaled that interest rates are close to peaking, European Central Bank Governing Council member Klaus Liebscher said.

The comments arrived as surveys of purchasing managers working for service providers and manufacturers showed the euro-zone economy continued to expand at a rapid pace in March, and the remarks implied that the central bank is likely to raise interest rates at least one more time this year.

"We will say that [rates are close to a peak] when the time comes," Mr. Liebscher, who is also the governor of Austria's central bank, said in an interview. He reiterated that interest rates are moderate and monetary policy is still supporting economic growth.

There are two reasons why the levels of various regions interest rates are important. The first is the carry trade. A "carry-trade" is an eco-geek way of saying, "borrow money in a region where interest rates are low and lend in regions where interest rates are high." Secondly, interest rates are important for currency traders. If a currency has a higher interest rate, traders will consider that currency more valuable. Some traders invest their currency holdings in that currencies interest rate investments.

Higher inflationary pressures mean higher interest rates. Higher interest rates mean a more valuable currency.

Also remember, there is slow global move to diversify currency reserves from dollars, primarily in euros. As European interest rates increase to stave off inflationary pressures expect this move to continue.

The following graph is from Barron's "The Current Yield", a weekly column on the bond market.

Bank of Japan Leaves Rates Unchanged

From the WSJ:

Bank of Japan board members Tuesday voted unanimously to leave monetary policy steady, in line with indications from the central bank that it wouldn't immediately follow a rate rise in February with a further policy tightening.

Analysts expect the BOJ to raise interest rates further but not until economic data show domestic demand is picking up and price pressures increase after moderating due to a recent fall in global oil prices.

The carry trade -- borrowing in Japan at low rates and lending in the US at higher rates -- has been an important source of financing for hedge funds for the last 5+ years. So long as the interest rate differential is still advantageous for the trade it will continue.

Tomorrow the US Federal Reserve will issue its interest rate policy decision. While there has been speculation the Fed will lower rates soon, I still think that is wishful thinking. We'll have to see how their official statement comes out, but I doubt we'll see much meaningful change.

Japan Raises Interest Rates

From the WSJ

The Bank of Japan on Wednesday decided to raise interest rates, breaking free from a policy impasse that had kept Japan's super-low borrowing costs unchanged since July, and indicating its continued effort to pursue its goal of slow but steady monetary tightening.

The central bank's nine-member policy board voted eight to one to boost the target for short-term rates by 0.25 percentage point to 0.5%. The move came after the BOJ decided against a rate increase in December and again in January amid persistent weakness in some economic indicators and calls from politicians to keep monetary policy unchanged.

The closely watched move marked the first change in Japan's monetary policy after the Bank of Japan in July ended its five-year-old policy of keeping its benchmark rate at zero.

Despite Wednesday's increase, economists expect the pace of future rate increase will remain slow, given the current sluggishness in personal consumption and slow increases in the consumer price index.

However, it's not a great booming economy yet:

Ativity in Japan's service sector fell for the second straight month in December as warm weather damped retail trade, adding to speculation that consumer spending in the world's second-largest economy has yet to fully recover.

...

Friday's data showed that the financial-services index climbed 0.8% in December from November, although wholesale and retail trade index fell 0.5%, which reflects the overall trend of consumer spending.

Japanese interest rates have been the root of much speculation among economists for some time. When will they start raising rates and how fast etc.. Well now they have made a first step. However, the recovery of the Japanese economy is still nascent, implying the interest rate policy could change.

Don't Worry -- It's Only an Inverted Yield Curve

From CBS Marketwatch:

But S&P says, in effect, that we shouldn't be worried.

Their argument, which appears in the Feb. 14 edition of flagship newsletter The Outlook, is that global capital flows have made this country's yield curve less important than it once was. As Alec Young, S&P's international equity strategist, puts it, "Capital flows around the world more freely than ever -- meaning the global yield curve is far more relevant in assessing U.S. economic and profit trends than its domestic counterpart."

What's the current picture painted by global interest rates? To find out, Young turned to a global yield curve in which each country's individual yield curve is weighted according to the share that its gross domestic product has of global GDP. In contrast to the U.S.'s inverted yield curve, this GDP-weighted global yield curve is positive right now, according to Young.

From USA Today:

Every recession since 1960 has been preceded by an inverted yield curve. The indicator's only wrong signal was in 1966, when the curve inverted but no recession followed.

The indicator carries logic behind it. The Federal Reserve pushes up rates to slow the economy, and bond traders push yields down if they smell a slowdown.

"The bond market is telling you they have a pessimistic view of the next 12 months," says Russ Koesterich of Barclays Global Investors.

But Koesterich thinks demand for long-term bonds, especially from China and oil-producing nations, has twisted the curve. As demand rises, yields fall.

Oil exporters held $97.1 billion in Treasuries at the end of November, up from $79.3 billion a year earlier. China's Treasury holdings have swelled to $347 billion, up from $303.9 billion a year before.

In other ways, too, globalization may be diminishing the yield curve's accuracy as a recessionary signal. On one hand, increases in the fed funds rate, the interbank overnight loan rate, can slow the economy. Banks must pay more for deposits. Consumers pay more for loans.

On the other hand, U.S. companies can now often borrow overseas at lower rates. The funds rate, for instance, is 5.25%; the European Central Bank rate is 3.5%. "Our own yield curve is less important when companies can borrow elsewhere," Kalish says.

OK -- I think the S&P argument is pretty weak. A global yield curve sounds like a really nice idea on paper, but I don't think it has much weight outside academia.

The USA Today article makes more sense. They are essentially arguing the following.

Company A is no longer constrained by US geographical boundaries when looking for loanable funds. For companies of a certain size this is true. For example, a company in the S&P 500 does have access to pretty much the whole world's capital pools if it so chooses. However, this argument assumes a low interest rate is the only cost involved in borrowing money. There is also currency risk which has to be hedged against. There may be a ton of other costs involved in borrowing in another country. For example, some countries may have different, more arduous legal requirements for off-shore borrowing. Then there is the cost of investigating and developing the offshore relationships to actually borrow offshore. Short version for borrowing offshore -- there are probably alot of hoops to jump through that go beyond the simple "it's cheaper over there" argument.

The article is also right about the "global savings glut". Basically, the flood of petro-dollars is returning to the US in some form with increased purchases of US Treasury bonds. That makes sense and I think it carries some weight. However, the International Monetary Fund made an observation at the beginning of 2006 that the "global savings glut" is really a decrease in Asian investment. At the beginning of the 21st century, Asian economies were investing at a lower rate. This freed up a large amount of international capital which looked for a new home. If Asian countries return to their previous level of investment, the US economy will be competing with Asian economies for these excess funds.

In addition, US financial institutions' profit margins are less constrained by the US yield curve. For the last 20 years, banks have worked diligently to develop revenue streams that are not dependent on borrowing short and lending long. For example, most banks have built up larger internal businesses that service loans which are more immune to yield curve fluctuations.

However -- and maybe I'm just an old fashioned economists who can't learn new tricks -- the inverted yield curve still bothers me. But I've been wrong before -- I thought Madonna was a 1-hit wonder, after all.

10-Year Treasury at 5-month Highs

From Bloomberg

Treasury 10-year note yields rose to the highest level since August this week after government bond sales drew weaker-than-expected demand and industry reports suggested the worst of the housing slump may be over.

Investors demanded higher returns on the $41 billion of securities sold as compensation for concern a strengthened economy will raise the threat of inflation. New- home sales rose more than expected and existing-home sales stabilized, the U.S. Commerce Department reported.

The government bond market has ``just been beaten down very hard,'' said Scott Gewirtz, head of Treasury trading at Lehman Brothers Inc. in New York, one of the 22 primary U.S. government securities dealers that trade with the central bank.

The yield on the benchmark 10-year note rose 10 basis points, or 0.10 percentage point, to 4.88 percent, according to bond broker Cantor Fitzgerald LP. It touched 4.90 percent yesterday, the highest since Aug. 16. The price of the 4 5/8 percent security maturing in November 2016 fell 24/32, or $7.50 per $1,000 face value, to 98 1/32.

For the last few months, talk of an interest rate cut has dominated trader's talk. I have speculated that an interest rate cut was off the table for now, largely based on numerous Federal Reserve speeches that said inflation was still too high. The Treasury market appears to share that view as the chart of the 10-year Treasury indicates:



Interest rate policy is the prime driver of the current expansion. Here is a chart from the St. Louis Fed of the effective Federal Funds rate:



The Fed lowered interest rates to 0% (after adjusting for inflation) by early 2002. Conventional economic thinking says it takes 12-18 months for interest rate changes to work their way through the economy. That would mean the last of massive cuts in 2001 fully hit the economy in early 2003 which is when overall GDP kicked into higher gear.

Now we have a Fed that is very concerned about inflation, as they have said so in a unified voice in their public speeches. Several non-official inflation measures (from the Cleveland and Dallas Fed) confirm inflation is still higher than the Federal Reserve would like. Therefore, a rate cut is still off the table, barring new economic numbers that work against that thesis.

So -- what does this mean going forward?

1.) Housing: We started to see better housing numbers in the last part of 2006. This is also when we saw interest rates drop. Therefore, don't be surprised if housing numbers fail to impress in the next few months.

2.) Borrowing costs are still historically low: 5% for capital is still cheap by historical standards. Therefore, don't expect a big dent in all of the M&A activity we have been seeing over the last half of 2006.

3.) The overall effect on consumer spending is a wild card. Pay is increasing, but consumers may want to allocate those increases to the record high debt payment level they currently have rather than spending on consumer goods. Also, the Christmas season was fair but not great, indicating consumer spending may already be slowing down.

10-Year Treasury and Housing

Talk of a housing bottom started sometime in October. Since then we've gotten more news on new and existing home sales to stoke talk of a housing bottom (We've also had home builders report some really lousy earnings reports). In addition, interest rates started to drop about that same time. Here's a chart of the 10-year Treasury from stockcharts.com



Rates have risen steadily since early December, largely because good economic news and public statements from various Fed governors dampened speculation of a rate cut in early 2007. As a result, the 10-year Treasury's interest rate is back near 4.84%. This was at least a non-restrictive interest level in October. We'll have to see if that still holds going forward.