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Sunday, October 20, 2019

Yield Curve Disinversion

Chart: 2/10 Treasury Slope

My main writing duties have been cleaning up my manuscript. One of the sections I was looking at discussed how the manuscript text was mainly written by early 2019, and I am not attempting to have it capturing the latest data. One scenario that was obviously embarrassing would be a recession starting before the official publication date.

If we are to believe the conventional interpretation of the yield curve, that odds of that outcome has receded. The figure above shows the 2-/10-year slope, which was only mildly inverted. (The 3-month/10-year slope is probably better as a recession indicator, but the 2-/10-year is the trading vehicle. Duration matching a 3-month bill versus a 10-year note is not exactly a sensible structure.)

We are back where have been for a few years: a dead flat curve. This is not necessarily a statement about recession risks, rather the direction of Fed policy. The lack of acceleration in the economy has to be telling Fed officials that their estimate of "neutral" rates has to be close to current levels. As such, the risks for the next move in interest rates is symmetric. Given the massive demand for duration matching and the age of the current cycle, there is no obvious reason why there should be a large positive term premium in the Treasury curve at this point.

My argument is that we need a large change in the propensity to invest in order to generate some cyclical excitement (in either direction). I confess ignorance as to what might cause such a change in animal spirits, as there are no obvious suspects for change, other than developments outside of North America.

As one final theoretical point, the Fed rate cuts will probably be interpreted as a triumph for interest rate policy by neoclassicals. One could use recession forecasting models based on the yield curve to argue that there was an elevated risk of recession. Policymakers note the risk in their meeting minutes, and cut rates in response. The curve disinversion lowers the estimated probability of a recession. Using the highly scientific "narrative" method that is approved by the "Top 5" economics journals, this means that monetary policy prevented a recession. Meanwhile, the fact that the theory that monetary policy is utterly ineffective is also consistent with observed data is not going to get published in a "Top 5" journal, and so we can safely ignore it.

(c) Brian Romanchuk 2019

4 comments:

  1. Brian will you have an updated post on Canada's sectoral balances? I know in past posts you have focused on the "micro" of CMHC insurance of pumping household debts and housing prices; but just going by the logic of sectoral balances, if Canada has a trade deficit with a negligible government deficit, doesn't this mean household debt would rise by the "macro" of the equation? I'm assuming here foreign savings is "causing" this although the sectoral balance accounting identity does not say which direction the casual forces are. I believe this is a similar argument that Ben Bernake used in arguing the savings glut of trade surplus nations distorted long-term rates in the US during their bubble years.

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    1. The business sector could borrow. I’d argue that household borrowing is largely doing what it wants (borrow to buy homes), and the external balance is being determined as the residual. (From what I recall, I think borrowing had slowed to be in line with income growth so household debt/income ratios were stabilising.)

      Statscan completely reorganised their data sets, and so I need to find the new tables to get data. I might take a look, but I really want to get my manuscript under wraps...

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  2. Do you agree with MMT's view on trade that exports are real costs and imports are real benefits? I hope to learn more on MMT's international trade views in the latest textbook by Mitchell and Wray. It's very counter to what I'm used to reading, with the employment benefits a nation can receive by exporting and thus importing foreign demand (in a world where demand is becoming scarcer).

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    1. Yes, running perpetual trade deficits means that you get real goods in exchange for financial claims. However, the issue of losing the capacity to manufacture goods does represent a long-term risk to prosperity. I think that is a cost to the outsourcing strategy pursued by a lot of the developed countries (e.g. the US). That said, a lot of people are happier that heavy industries are polluting areas they can’t see.

      Delete

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