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Yield Curve, The Fed and the future........

John Mauldin Says:


Let's start with a review of the yield curve. Basically, it is the difference between short term and long term rates. When short term rates rise above long term rates, the curve is said to go "negative" or "inverted." This is important, because as Professor Campbell Harvey (at the Fuqua School of Business at Duke) first pointed out in his doctoral dissertation at the University of Chicago, the yield curve is the best predictor of an impending recession.

(As an aside, for you research buffs, his web site has a very easy to use dictionary for every conceivable financial term, with lots of links. http://www.duke.edu/~charvey/, plus lots of other really good material.)

Typically, when the yield curve goes negative for about 90 days or more, the country goes into recession within 12 months. Thus, with the yield curve getting flatter and flatter, people like me start to pay closer attention. Because, while it should seem obvious, a necessary pre-condition for a negative or inverted yield curve is a flattening yield curve.

In one sense the yield curve is already much flatter. As I will point out below, the Fed has made it clear they intend to keep raising rates. If they raise at the next three meeting, the curve will be quite flat. The market is pricing in such Fed moves, so essentially the market is anticipating a much flatter yield curve. The question of the day is whether the Fed will deliberately force an inverted yield curve.

Of course, when short term rates rise above long term rates, this is not good for banks. They have to "pay" for money by giving interest and charging more for their loans. When short term money goes above long term money, it puts a squeeze on their profits. They also tend to lend less money and become more conservative, which puts a crimp on business in general.

But here was the logic: over the long term, there was (from 1945 to 1995) a rough adequation between three variables

  • the growth rate of nominal GDP
  • the growth rate of corporate profits
  • long interest rates

"This adequation meant that the long rate gave a rough estimate of the standardized growth rate of corporate profits. And as we never tire of writing, corporate profits are what the entrepreneurs (the fellows taking risks) get. Meanwhile, the rentiers (the fellows taking no risks) get the returns provided by short rates. So when short rates move close to, or above, long rates, the rentiers start to make more money than entrepreneurs. An economic system in which this is happening moves rather rapidly "ex growth". This is why, when the yield curve would invert, within a year, a recession was on.

"Indeed, with the 'platform company' business model, we find that:

  • "Corporate profit growth in the US over the past decade has been much stronger than GDP growth and is likely to remain so. How is this possible? Could the fact that corporate profit growth in China has been much weaker than the GDP growth have something to do with it? Very possibly...after all, when you sell stuff to Wal-Mart, only Wal-Mart is allowed to make real money on the trade!
  • "Most companies are now structurally in a positive cash flow mode (if, like Ikea, Dell, H&M...) you focus solely on design and sales, how much capital do you really need?
  • "Commercial banks which used to provide up to 90% of the financing needed by the economy are now providing around 35%. This helps remove cyclicality and interest rate sensitivity.

"The 'platform company' revolution means that, in all of our models, we have to replace long rates by the structural growth rate of the economy. This makes our job, and the central bankers' jobs, a little more challenging."

They argue that the movement of the yield curve is not particularly useful at other times other than when it is negative. It is only when it goes negative that we should really pay attention. You can go the paper and see the "before and after" LEI and see that it does seem to in fact work better only using the yield curve when it is negative. You can also see that the LEI is now turning down on page 6 of the report. (http://www.conference-board.org/economics/bci/NewYieldLEI_2005.pdf)

So why is the Fed clearly signaling they are going to raise rates at least another two times and probably much higher? I think the Fed is no longer targeting inflation. From their speeches and from the minutes of the meetings, I think they are clearly targeting asset prices and specifically housing. They are worried about a bubble. "It is not a bubble yet," says Greenspan, "just a little froth here and there."

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