Friday, May 29, 2009

Tim Bond of Barclays even reckons the yield curve may be a good sign, signalling an increased appetite for risk

From Free Exchange:

"Green shoots whither on the long end of the curve
Posted by: | NEW YORK
Financial markets

REMEMBER a few years ago when everyone was so concerned about the inverted yield curve? Exactly what the shape of the yield curve can tell you about the future remains a mystery to economists. Some people presume an upward sloping yield curve forecasts growth, but an inverted curve signals imminent recession. A curve goes flat or becomes inverted when investors expect lower rates of inflation or the Fed to increase short-term rates. Each of these scenarios is associated with a decline in economic activity.

It turns out that the inverted curve did predict the latest recession, but for different reasons. Implicit inflation targeting appeared to be working; high and unpredictable inflation was relegated to emerging markets. That decreased the premium on long-dated government bonds. The savings glut also lowered long-term yields by increasing the demand for long-term governments, lowering their yields. In retrospect the inverted curve, reflecting the influx of capital (which fed the bubble) and faith in long-run price stability (which made us complacent about risk), did signal our undoing, but for reasons we did not anticipate.

You might think, then, that there would be some relief that the yield curve steepened this week, but stocks fell 2%. It should not have come as any surprise. Any even remotely credible rumblings about America losing its AAA rating is bound to increase long-term yields. Worries about inflation in the future, as a result of current Fed policy, also have driven yields higher. In light of this, I find it remarkable that ten-year Treasuries only jumped 20 basis points yesterday, to 3.7%. I've heard it speculated that Treasuries may ultimately reach 4 or 5%, but even that is fairly low compared to historical rates. That's still cheap capital. (Though a 20-basis-point jump is rather startling, especially because everyone is waiting on markets to drop treasuries.)

This week Buttonwood weighs in on the issue. On the surface, worries about the sustainability of American debt are strange. It is unlikely that America will default on its loans, though it may let its currency decline or inflate away some of its debt. And the world still lacks a viable alternative reserve currency or risk-free asset. Tim Bond of Barclays even reckons the yield curve may be a good sign, signalling an increased appetite for risk.

The yield curve just can't win, inverted or steep it always seems to signal disaster ahead."


Don the libertarian Democrat wrote:

May 29, 2009 17:01

I agree with him, as does Richard Fisher:

"Meanwhile, Reuters reported, "Federal Reserve Bank of Dallas President Richard Fisher said on Thursday it was not clear if the U.S. Treasury yield curve was steepening because of concerns over supply or a more optimistic economic outlook. "Obviously, there is a lot of supply of debt. Another way to interpret the steepening of the yield curve is ... confidence in economy going forward," he told reporters after a speech, adding that both could be happening at the same time. "I think it is probably a little bit of both, discounting the supply of new debt, but I detect...there is a pick up in confidence about the future," said Fisher."

In my book, this is how QE is supposed to work,ie, low short term interests rates and rising longer term interest rates. It's working. Now, of course, at some point, higher interest rates will become a problem, but we're a bit away from that now. So, the negative comments are reasonable, and might turn out to be right. We might, possibly, lose control down the road. I simply disagree.

By the way, haven't we all learned that we're all highly fallible in predicting the future yet?

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