In the past week or so I’ve see more and more people worrying about the flattening of the Treasury yield curve. I’ve also seen breathless stories about how the nation’s malls are emptying, subprime auto loan defaults are surging, and student loans are defaulting. While these are all disturbing developments, a lot of other things will need to happen before the economy is at risk of falling into another recession…The following charts put some meat on my argument.
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The following charts drill down into these factors to see how they stack up and what they mean.
- real interest rates (blue line) have risen sharply,
- and the Treasury yield curve has gone flat or inverted (red line).
That’s another way of saying that the Fed has been the proximate cause of every recession in modern times. They have tightened monetary policy to such an extent that the economy just couldn’t take it anymore.
Until 2008, when Quantitative Easing started, the Fed tightened policy by withdrawing bank reserves from the financial system. Banks need reserves to back up their deposits, so when reserves become scarce they must pay more to get the reserves they need. This
- pushes up short-term interest rates
- and results in a general scarcity or shortage of liquidity.
Rising rates and tighter liquidity conditions start eroding the economy’s underpinnings. The economic and financial fundamentals deteriorate until people are forced to sell and panic ensues.
This time around, however, things are VERY different. Because of Quantitative Easing, the Fed can’t tighten like they used to. They can’t even begin to make bank reserves scarce enough to forces short-term rates higher.
As Chart #3 below shows, there are about $2 trillion of excess reserves in the system: way more than banks need to back up their deposits. The Fed gets around this by paying interest on reserves, which it never did before. In the old days banks always wanted to minimize their reserve holdings because they paid no interest. Nowadays banks don’t worry so much, because reserves pay interest that is close to what T-bills pay; reserves are an asset today, whereas they were a deadweight loss before.
By increasing the rate it pays on reserves, the Fed directly impacts all short-term interest rates without there being any shortage of liquidity, so this tightening cycle that we are now in will be very different from past tightening cycles, because it will be a long time (years) before the banking system approaches the point at which bank reserves become scarce.
The Fed is going to unwind its balance very slowly. The Fed can “tighten” by raising short-term interest rates, but they can’t create a shortage of liquidity like they did before so it’s not surprising that despite higher short-term interest rates and a flattening of the yield curve, there is, as yet, no sign that financial market conditions are deteriorating, as the following charts demonstrate.
- flatter and inverted curves are always the result of short-term interest rates rising by more than long-term interest rates. That’s the Fed in action.
- the yield curve can be fairly flat, as it is today, for many years before a recession hits (e.g., the mid-90s). To really squeeze the economy, you need not only a flat curve but much higher interest rates and a shortage of liquidity.
As charts 7 and 8 below show, credit spreads are fairly low. Despite the news of defaults in certain sectors of the economy, investors by and large are not worried much about widespread defaults. This also tells us that the Fed hasn’t really tightened at all. Corporations can borrow as much as they want without having to pay onerous interest rates.
Until we see:
- the yield curve actually invert,
- real yields move substantially higher,
- swap and credit spreads moving significantly higher,
- and until inflation expectations move significantly higher,
a recession is very unlikely for the foreseeable future.
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