Stocks RISE On Perfect Track Record of Recession

If this doesn't spell B-U-B-B-L-E, what does? The last time it happened, the bubble popped then, too!

David Robsenberg at Bloomberg said this today:

"We now have had three months of a 3-mo/10-yr yield curve inversion. The track record this has had in predicting recessions: 100%."

Treasury Yield Inversion Signals Recession

is this why the Dow is down 600+ points this morning? That's about 100 points more than the rise is stocks at their peak yesterday. Look out, because trouble is coming!
This treasury yield curve inversion is one of the most accurate recession signals in history! It hasn't been wrong once in the past half century! This is a huge red flag!

Yield Curve Debate

fantastic from Zero Hedge:

Rich Bernstein who while at BofA used to be one of the few (mostly) objective voices, today got into a heated discussion with Rick Santelli over yield curves and what they portend. In a nutshell, Bernstein's argument was that a steep yield curve is good for the economy, and the only thing that investors have to watch out for is an inversion. Yet what Bernstein knows all too well, is that in a time of -7% Taylor implied rates, QE 1, Lite, 2, 3, 4, 5, LSAPs, no rate hikes for the next 3 years, and all other possible gizmos thrown out to keep the front end at zero (as they can not be negative for now), to claim that the yield curve in a time of central planning, is indicative of anything is beyond childish. A flat curve, let alone an inverted curve is impossible as this point: all the Fed has to do is announce it will be explaining its Bill purchases and watch the sub 1 Year yields plunge to zero. Yet the long-end of the curve in a time of Fed intervention is entirely a function of the view on how well the Fed can handle its central planning role: after all, the last thing the Fed wants is a 30 year mortgage that is 5%+ as that destroys net worth far faster than the S&P hitting the magic Laszlo number of 2,830 or whatever it was that Birinyi pulled out of his ruler. As such, Santelli's warning that a steep curve during POMO times is just as much as indication of stagflation as growth, is spot on.
Furthermore, to Bernstein's childish argument of "where is the stagflation" maybe he should take a look at commodity prices, unemployment levels and double dipping home prices, and the answer will suddenly become self evident. But either way, the point is that during central planning the shape of the curve does not matter at all, and certainly not to banks. The traditional argument that banks make more money on the long end breaks down when nobody is borrowing on the long-end, and with mortgage apps, both new and refi, plunging to fresh lows, that is precisely what is happening. But who cares about facts: all one has to do is roll one's eyes and smile flirtatiously at Becky Quick (making sure of course that Warren is nowhere to be found).
The video of the argument between the two is below:
Regardless, while Bernstein's objectivity is now sadly very much under question, if understandably so as his new business requires a bullish outlook no matter what, here is a primer on curves that was posted on Zero Hedge previously for all those who may have been confused by today's debate.
Posted on Zero Hedge in June 2010:
Why the Yield Curve May Not Predict the Next Recession, and What Might

Gone Are the days when "green sh#%ts" was bleated daily on CNBC amongst a chorus of permabull snorts. Even the experts now recognize the recovery as a BLS swindle, and it is important to reintroduce the possibility of not only a low growth future, but one of outright and persistent contraction. As “double dip” has recently worked its way into the popular lexicon, we will explain why a traditional forecasting tool of recessions may not flash a warning this time around. Afterward, we explore why even “double dip” may not be an accurate term, as well as what a cutting edge-new economic indicator is forecasting.

Gary North wrote an excellent article explaining why yield curve inversions predict recessions. It is instructive now to illustrate how the fundamental backdrop has changed amidst unprecedented government intervention.

The interest rates for more distant maturities are normally higher the further out in time. Why? First, because lenders fear a depreciating monetary unit: price inflation. To compensate themselves for this expected (normal) falling purchasing power, they demand a higher return. Second, the risk of default increases the longer the debt has to mature.

In unique circumstances for short periods of time, the yield curve inverts. An inverted yield occurs when the rate for 3-month debt is higher than the rates for longer terms of debt, all the way to 30-year bonds. The most significant rates are the 3-month rate and the 30-year rate.

The reasons why the yield curve rarely inverts are simple: there is always price inflation in the United States. The last time there was a year of deflation was 1955, and it was itself an anomaly. Second, there is no way to escape the risk of default. This risk is growing ever-higher because of the off-budget liabilities of the U.S. government: Social Security, Medicare, and ERISA (defaulting private insurance plans that are insured by the U.S. government).

We are no longer in a persistently inflationary environment, despite the best multitrillion-dollar reflationary efforts to the contrary. Disinflation and outright deflation keep popping up in critical areas of the economy. While the central banks will likely overshoot in the end, resulting in an hyperinflationary spiral, for the time being, lenders are not worrying about inflation. And, while one may doubt the BLS’ calculation expressed by the Consumer Price Index, the below chart of CPI year-over-year is nonetheless striking, as it indicates the recent crisis brought it into the most negative territory since inception.

On the rise are medical and food costs, but continued deleveraging by banks and consumers are offsetting deflationary drags. Banks are writing down (and off) private and commercial real estate loans, and consumers will remain in spending retrenchment as long as they continue to work off credit in a high unemployment environment. Indeed, year over year consumer credit is in the most negative territory post-WWII.

Though headline civilian unemployment from the BLS’ household survey is ticking down from the ominous 10% level, this is largely a result of the birth/death model adjustmentand the removal of so-called discouraged workers from the counted pool. When viewed from the larger perspective of the civilian employment to population ratio, the job losses are staggering and unprecedented in the modern era. When the economy eventually does show improvement, these discouraged workers will reenter the job market and keep the headline unemployment rate persistently high.

Finally, creation of money supply, as expressed by non-seasonally adjusted year-over-year M2, continues to reflect slow money growth, notwithstanding the trillion or so in excess bank reserves sitting at the Fed earning interest at 0.25%. The very fact that banks are content to earn interest at this absurdly low rate indicates risk aversion and little fear of inflation.

North continues:

What does an inverted yield curve indicate? This: the expected end of a period of high monetary inflation by the central bank, which had lowered short-term interest rates because of a greater supply of newly created funds to borrow.

The obvious failure of the central banks to reflate the economy has now renewed fears that monetary inflation will not return for some time.

This monetary inflation has misallocated capital: business expansion that was not justified by the actual supply of loanable capital (savings), but which businessmen thought was justified because of the artificially low rate of interest (central bank money). Now the truth becomes apparent in the debt markets. Businesses will have to cut back on their expansion because of rising short-term rates: a liquidity shortage. They will begin to sustain losses. The yield curve therefore inverts in advance.

On the demand side, borrowers now become so desperate for a loan that they are willing to pay more for a 90-day loan than a 30-year, locked in-loan.

Aside from government darlings, businesses and critically, small businesses, have largely stopped expanding and are in defensive retrenchment. The problem is a reduction in both the supply and demand for new loans. There is definitely a liquidity shortage, but it is being expressed unconventionally as central bank quantitative easing and government stimulus are directed into non-productive parts of the economy. It is these zombie behemoths in the financial and transportation sectors that are most desperate for funds, yet they are not penalized for it. Instead, they are encouraged to feed at the government trough even as their smaller (and more productive) competitors are edged out through oppressive regulation and inability to access loans at a similar rate. This will continue to be a drag on overall growth, and without small business growth, the threat of recession relapse is greatly heightened.

On the supply side, lenders become so fearful about the short-term state of the economy -- a recession, which lowers interest rates as the economy sinks -- that they are willing to forego the inflation premium that they normally demand from borrowers. They lock in today's long-term rates by buying bonds, which in turn lowers the rate even further.

Though long term US Treasurys are benefitting from safe haven flight-to-quality status, short term Treasurys are similarly benefitting to a greater degree, thus widening the spread between the two. As stated above, banks are content to park over a trillion dollars in excess reserves at the Fed earning interest at 0.25%. A combination of a (currently low but slowly rising) fear of eventual US default, extreme desire for short term safety in T-Bills, and low fear of inflation is keeping the spread wide. Also troubling is the recent disconnect between short term Treasury yields and the borrowing rates actually available to businesses with excellent credit.

North concludes:

An inverted yield curve is therefore produced by fear: business borrowers' fears of not being able to finish their on-line capital construction projects and lenders' fears of a recession, with its falling interest rates and a falling stock market.

Indeed, these are the fears being expressed, but in different manners that are not immediately obvious. Small productive businesses are throwing in the towel as their larger competitors build Potemkin villages.

A further problem is that nearly all yield curve studies look back no further than the mid-1950’s, the inception of Fed data on US Treasury rates. Inasmuch as every recession since then (save the last) has been manufacturing based as opposed to credit based and has occurred in an overall inflationary backdrop, there lacks a crucial window into prior deflationary times concurrent with extreme government meddling—in particular, the Great Depression.

Many economists from the Austrian school follow M2 money supply as a harbinger of economic growth or contraction, as it tracks the creation and destruction of money through economic activity at the margins. As noted previously on EPJ, Rick Davis and others at the Consumer Metric Institute have created a novel indicator that tracks, in real time, consumer demand for capital goods. Accordingly, it should and does reflect similar activity, though with enhanced granularity. Indeed, it anticipates US GDP by an average of 17 weeks. A future post will explore this aspect of their data and possible uses for market timing. For now, Davis tells a different story than the governments that collude to forge a statistical recovery:

Our 'Daily Growth Index' represents the average 'growth' value of our 'Weighted Composite Index' over a trailing 91-day 'quarter', and it is intended to be a daily proxy for the 'demand' side of the economy's GDP. Over the last 60 days that index has been slowly dropping, and it has now surpassed a 2% year-over-year rate of contraction.

The downturn over the past week has emphasized the lack of a clearly formed bottom in this most recent episode of consumer 'demand' contraction. Compared with similar contraction events of 2006 and 2008, the current 2010 contraction is still tracking the mildest course, but unlike the other two it has now progressed over 140 days without an identifiable bottom.

As we have mentioned before, this pattern is unique and unlike the 'V' shaped recovery (or even the 'W' shaped double-dip) that many had expected. From our perspective the unique pattern is more interesting than the simple fact of an ongoing contraction event. At best the pattern suggests an extended but mild slowdown in the recovery process. But at worse the pattern may be the early signs of a structural change in the economy.

While confounding the average GE cheerleader, this new normal of increasing destructive intervention is intuitively understood by the consumer, who responds to this reality by pocketing the debit card. So what can we expect in the ensuing quarters?

Davis aptly describes what has happened so far:

[I]t has instead, unfolded so far as a mild but persistent kind of
contraction, more like a 'walking pneumonia' that keeps things miserable for an
extended period of time.

Until governments stop punishing innovation, stop rewarding incompetence, stop distorting economic signals with arbitrary econometric targeting, stop coddling failures--we will continue to walk with this pneumonia indefinitely. The solution, as always, is nothing. Stop intervening and let the chips fall where they may. Markets will correct things faster than you might think.

---

And here is a useful primer from Fidelity on the various shapes of the yield curve and what they indicate:

Normal and Not Normal

Ordinarily, short-term bonds carry lower yields to reflect the fact that an investor's money is under less risk. The longer you tie up your cash, the theory goes, the more you should be rewarded for the risk you are taking. (After all, who knows what's going to happen over three decades that may affect the value of a 30-year bond.) A normal yield curve, therefore, slopes gently upward as maturities lengthen and yields rise. From time to time, however, the curve twists itself into a few recognizable shapes, each of which signals a crucial, but different, turning point in the economy. When those shapes appear, it's often time to alter your assumptions about economic growth.

To help you learn to predict economic activity by using the yield curve, we've isolated four of these shapes -- normal, steep, inverted and flat (or humped) -- so that we can demonstrate what each shape says about economic growth and stock market performance. Simply scroll down to one of the curve illustrations on the left and click on it to learn about the significance of that particular shape. You can also find similar patterns within the past 18 years by running our "yield-curve movie" and -- by clicking the appropriate box -- you can compare any shape within that time period to both today's curve and the average curve.

Normal Curve
Date: December 1984

When bond investors expect the economy to hum along at normal rates of growth without significant changes in inflation rates or available capital, the yield curve slopes gently upward. In the absence of economic disruptions, investors who risk their money for longer periods expect to get a bigger reward -- in the form of higher interest -- than those who risk their money for shorter time periods. Thus, as maturities lengthen, interest rates get progressively higher and the curve goes up.

December, 1984, marked the middle of the longest postwar expansion. As the GDP chart above shows, growth rates were in a steady quarterly range of 2% to 5%. The Russell 3000 (the broadest market index), meanwhile, posted strong gains for the next two years. This kind of curve is most closely associated with the middle, salad days of an economic and stock market expansion. When the curve is normal, economists and traders rest much easier.

Steep Curve
Date: April 1992

Typically the yield on 30-year Treasury bonds is three percentage points above the yield on three-month Treasury bills. When it gets wider than that -- and the slope of the yield curve increases sharply -- long-term bond holders are sending a message that they think the economy will improve quickly in the future.

This shape is typical at the beginning of an economic expansion, just after the end of a recession. At that point, economic stagnation will have depressed short-term interest rates, but once the demand for capital (and the fear of inflation) is reestablished by growing economic activity, rates begin to rise.

Long-term investors fear being locked into low rates, so they demand greater compensation much more quickly than short-term lenders who face less risk. Short-termers can trade out of their T-bills in a matter of months, giving them the flexibility to buy higher-yielding securities should the opportunity arise.

In April, 1992, the spread between short- and long-term rates was five percentage points, indicating that bond investors were anticipating a strong economy in the future and had bid up long-term rates. They were right. As the GDP chart above shows, the economy was expanding at 3% a year by 1993. By October 1994, short-term interest rates (which slumped to 20-year lows right after the 1991 recession) had jumped two percentage points, flattening the curve into a more normal shape.

Equity investors who saw the steep curve in April 1992 and bet on expansion were richly rewarded. The broad Russell 3000 index (right) gained 20% over the next two years.

Inverted Curve
Date: August 1981

At first glance an inverted yield curve seems like a paradox. Why would long-term investors settle for lower yields while short-term investors take so much less risk?

The answer is that long-term investors will settle for lower yields now if they think rates -- and the economy -- are going even lower in the future. They're betting that this is their last chance to lock in rates before the bottom falls out.

Our example comes from August 1981. Earlier that year, Federal Reserve Chairman Paul Volker had begun to lower the federal funds rate to forestall a slowing economy. Recession fears convinced bond traders that this was their last chance to lock in 10% yields for the next few years.

As is usually the case, the collective market instinct was right. Check out the GDP chart above; it aptly demonstrates just how bad things got. Interest rates fell dramatically for the next five years as the economy tanked. Thirty year bond yields went from 14% to 7% while short-term rates, starting much higher at 15% fell to 5% or 6%. As for equities, the next year was brutal (see chart below). Long-term investors who bought at 10% definitely had the last laugh.

Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown -- or outright recession -- as well as lower interest rates across the board.

Flat or Humped Curve
Date: April 1989

To become inverted, the yield curve must pass through a period where long-term yields are the same as short-term rates. When that happens the shape will appear to be flat or, more commonly, a little raised in the middle.

Unfortunately, not all flat or humped curves turn into fully inverted curves. Otherwise we'd all get rich plunking our savings down on 30-year bonds the second we saw their yields start falling toward short-term levels.

On the other hand, you shouldn't discount a flat or humped curve just because it doesn't guarantee a coming recession. The odds are still pretty good that economic slowdown and lower interest rates will follow a period of flattening yields.

That's what happened in 1989. Thirty-year bond yields were less than three-year yields for about five months. The curve then straightened out and began to look more normal at the beginning of 1990. False alarm? Not at all. A glance at the GDP chart above shows that the economy sagged in June and fell into recession in 1991.

As this chart of the Russell 3000 shows, the stock market also took a dive in mid-'89 and plummeted in early 1991. Short- and medium-term rates were four percentage points lower by the end of 1992.

The Ominous Sign of the Yield Curve

There's no surefire way to forecast recessions. But watching the "yield curve" comes awfully close.
Essentially the difference between long term and short term U.S. government debt yields, the yield curve is a powerful harbinger of recessions and recoveries. Nearly every time the yield on short-term debt has surpassed the yield on long-term debt—what's known on Wall Street as an "inversion"—a recession has followed.

Minding for a Minsky Moment

from ZeroHedge:
Today, the yield curve hit a record. At 380 basis points, which incidentally was the widest spread between the 2 Year and the 30 Year ever, it has never been easier for banks to make money on the short-long interest spread.

Indeed, there are some wacky things happening in bond land. Recently, just like in the days after Lehman imploded, short-maturity bills traded at negative yields. While that particular rush for short maturities was at the time explained by a desire for year end window dressing and cash parking, the continued exuberance in bills (see chart below) can no longer be explained that simply.

There are a variety of explanations as to this surge in steepness, as well as for a continued preference of the short end of the curve. Some of these include the desire of foreign buyers to minimize duration, and as we have been pointing out over the past several months by deconstructing TIC data, the bulk of foreign purchasing has been in the Bill sector. And while there is no shortage of Bill interest, the traditional 30-Year buyers have shunned the long-end, and instead are opting for corporates for a better duration-risk profile. This is further coupled with the global doctrine of moral hazard which has made corporate failure essentially a thing of the past. With Bernanke onboarding private risk to the public balance sheet, the next big blow up will undoubtedly be sovereigns themselves. This is, in fact, confirmed by a glance at the spread between the SovX and the ITRAXX MAIN ex-FINS: for the first time in history, it is riskier to be a sovereign that it is to be an IG credit (green line on chart below).

So with the sweet spot in governments being exclusively Bills, it is natural to see further steepening, as more and more investors avoid the long end due to increasing sovereign and perceived inflation risk.
Yet there is nothing inherently wrong with steep curves. The bogeyman in credit land has always been the flat (or, heaven forbid inverted) curve. As CreditSights characterizies the flat curve situation:

A flat yield curve usually occurs when the market is making a transition that emits different but simultaneous indications of what interest rates will do. In other words, there may be some signals that short-term interest rates will rise and other signals that long-term interest rates will fall. Investors are uncertain and the margin for error is high. Tails get fat. Black Swans fly. X-Factors propagate.

What are the benefits of steep curve? They are numerous for all investor classes: i) a steep curve allows a wide margin for error, which incentivizes yield seeking lower in the capital structure, primarily equities; ii) banks can borrow cheap and lend expensive, which is a green light to "print money", and iii) a knee-jerk trading response to a steep curve is to buy equities, which creates a self-referential feedback loop, whereby steepness leads S&P higher, which increases asset prices, and hikes inflation expectations, which leads to an even steeper curve. The relationship is mapped on the chart below:

Lastly, by pushing yields down, the Fed is naturally trying to encourage the "virtuous cycle" of encouraging consumption and corporate investment. When inflation expectations are high and rates are low, companies and individuals are encourage to borrow as they should anticipate this debtload will be inflated in the future. However, judging by the latest consumer credit report and exorbitant excess reserve levels, Bernanke's plan has failed, as only Goldman et al can borrow at the short end.
In the current environment, in which economic reality is disjointed with the market, the steep curve is a source of concern. As CreditSight notes:

A steep yield curve can be a good thing. It should help the economic recovery and debt and equity markets. One could even argue that the Fed has done its job. ZIRP-American-style has both helped repair banks balance sheets and forced investors to take on riskier assets. Steep yield curves are generally seen at the end of a recession, when the economy is about to kick into full-gear.

So why all the worry? Well here is the rub: the evidence for economic expansion or the elements that make up an upward sloping yield curve are just not there yet. While it is a lagging indicator, credit creation has been scant. A recent survey from the Federal Reserve showed that since peaking in July 2008, consumer credit is down more than 4.8 percent. Bank lending is also down more than 8 percent over the past 12 months. Without a recovery in credit, there can be no self-sustaining economic recovery.

Also, it is interesting that we are seeing inflationary expectations when there is a complete lack of wage or producer price pressure. Employment (also a lagging indicator) has been weak and consumption continues to decline (though given its historic rise over the past decade, this could be a good thing). None of this seems consistent with a steep yield curve.

One certain outcome of a steep curve is dollar debasement: one of the goal of the Fed all along. And as Zero Hedge has been noting for almost half a year, the current FX dynamics are such that the dollar has supplanted the Yen to become the funding currency of choice (much to the chagrin of the BOJ). Logically, the question arises: how big is the carry trade?
From CreditSights:

The carry trade notably reared its wild and wooly head during the late 90s, when Japan announced a Zero Interest Rate Policy (sound familiar). Traders sold short the yen and bought just about anything else they could find, because everything was higher yielding. Indeed, if you were a mortgage trader, chances are you funded trades in yen. If you traded emerging markets, you crossed in yen. Baseball cards? Sell yen. Before the last time the world blew up, way back in 2007, the yen carry trade was estimated to be about $1 trillion (but who knows for sure). When the credit crisis hit, this trade was unwound, quickly. The dollar was (is) still the world’s reserve and money flocked to safety. Dollars were needed. The carry trade was killed and people lost big.

How do we tell there is a dollar carry trade? First off, Chairman Bernanke seemed to give the carry trade his blessing during his recent speech at the NY Economic Club, firmly saying that interest rates will not be raised in the short term. This gives traders license to sell dollars, not fearing that the Fed will raise rates and they will be caught out short.

Second, correlation. Everything seems to be correlated to everything (and we know how well that ended in 2007).

As the dollar weakens, investors look to harder or higher-yielding assets to contain some of the depreciation effects, causing asset classes to rise in tandem. In a recent piece, we pointed out that the correlation between equities and debt had an R-squared of greater than 90 percent. Dollar-equities, same thing, but inverse. Indeed, this is the first time since 1938 that we have had zero interest rates, dollar depreciation and equity markets rising. High yield continues to receive record inflows, despite coupons and current yield falling far short of extraordinary. Gold is also at record highs.

Zero Hedge has previously discussed why due to a funding mismatch, the globalized economy was on the dollar shortfall hook for a number as large as $6.5 trillion, which in turn explained why the Fed has to rush to save all Central Banks by pumping hundreds of billions of FX liquidity lines.

And here comes the first estimate ever attempted at quantifying the Fed sponsored "Dollar Destructive" moral hazard: the upper bound of the total loss in the case of a major liquidity event occurring with the Fed's complicit bailout on the table would amount to a staggering $6.5 trillion from a dollar duration funding mismatch alone! This is an astounding, unfathomable and untenable number. Yet it is likely the same now as it was at the onset of the Lehman crisis...As the H.4.1 discloses weekly, the Fed's liquidity swaps are now back to almost zero. This means that foreign Central Banks believe they have the FX swap and dollar maturity situation under control. They thought the same before Lehman blew up. And they were wrong. As the DXY continues tumbling ever lower to fresh 2009 lows, the trade de jour is once again the dollar funding one, although unlike before when the Yen was the carry currency of choice, this time it is the dollar itself, positioning banks for the double whammy of not just a dollar funding shock, but one coupled with a potential massive and historic short squeeze. If and when an exogenous event occurs, not even $6.5 trillion in Fed swap lines will be sufficient to bail out the world economy.

We wrote this in October 2009, before Roubini et al became dollar carry trade experts. We would like to highlight that the last time around, the dollar funding risk did not include the incremental need to cover hundreds of billions if not trillions in dollar shorts. The next time there is a risk flaring scenario, the cost to fund the dollar mismatch will be even greater due to additional rush to cover shorts.
The Minsky Moment
Today we pointed out that the VIX is at multi-year lows: complacency once again reigns supreme. So if indeed the market is correct, and growth is back, the Fed presumably has the tools required to facilitate and unwind, whether it is rising rates or using reverse repos. A return to Fed normalcy, however is not in the cards, as Bullard's presentation earlier highlighted. In fact, look for more Q.E., and more ZIRP.
So what happens if the optimists are wrong. A CreditSights readers makes the following observations:

I think what you are suggesting is a reversal of the high beta compression trade; we haven’t really seen economic recovery, just return from the precipice, so the markets have probably gone too far too fast.

Of course the brutality of the unwind in the carry trade depends on what moves the Fed off its mark. If it is inflation concerns, fixed income asset prices are dead and probably equities too, just on the discount factor. If it is due to real signs of economic recovery, then the carry trade unwind is mitigated by dollars chasing the economic recovery story in credit and equities. Third possibility is that the Fed intervenes on concerns about dollar weakness, but I really don’t see that happening.

To which CreditSights responds:

To have a dampening effect on dollar depreciation, the Fed would have to raise interest rates early and dramatically. Drawing from Chairman Bernanke’s recent statements, high unemployment and worries about choking off the recovery too soon are of greater concern. Also, a weak dollar solves a lot of problems for the US—of course, it creates problems for the rest of the world. But, as long as the US’s creditors are willing to accept dollar denominated debt, currency devaluation has to dual effect of monetizing the US’s debt and helping rebalance the trade deficit. But what happens if the world is no longer willing to accept Uncle Sam’s IOU? Last I checked, the US had some pretty big deficits it needs to finance.

The last is precisely what keeps PIMCO's Bill Gross at night, and is one of the main reasons why we believe the Fed has no option but to continue with Quantitative Easing...No option but to perpetuate the status quo which will merely make the ultimate unwind truly unprecedented.
The confluence of all these risk factors implies that there are simply too many variables for the Fed to be able to sustain control over what is an inherenetly chaotic situation:

An overly steep yield curve, combined with run away dollar depreciation generally indicates that authorities have lost control. There is a legitimate and real risk that the long-end could become “unstable,” as supply/inflation fears kick in. While consumer leverage is declining, leverage in the financial world is on the rise. And, it does feel like we have been here before: 2002, 2007—the  so-called Minsky Moment years.

We have come full circle, only this time it took a mere two years. As Justin Lahart so effectively summarized some years ago:

At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they've taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. "This is likely to lead to a collapse of asset values," Mr. Minsky wrote.

When investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash. At that point, the Minsky moment has arrived.

The Minsky moment is, once again, knocking on the door.

Yield Curve Interpretation

from Crossing Wall Street:
Now that the Federal Reserve has lifted its tightening bias, I wanted to take a look at the impact of lower interest rates on the stock market.
Since 1962, there have been 11,250 days when stocks and bonds have traded on the same day. The yield on the 90-day Treasury rose on 4,845 days, fell on 4,925 days and stayed the same on 1480 days.
On all the days when the T-Bill yield rose, the S&P 500 lost a combined 61.9%. Annualized, that works out to a rate of -4.9% (just capital gains, not dividends).
On the days when the T-Bill yield fell, the S&P gained a combined 1,739.1%, or 16.1% a year.
Interestingly, the market did the best when rates stayed the same. The S&P gained 182.3%, or 19.4% a year.
With long-term rates (10-year T-Bond), the impact is much more dramatic.
The 10-year yield rose on 4,885 days for a combined S&P loss of 98.8%, or -20.5% a year. That's basically a bear market.
The yield stayed the same on 1529 days for a combined S&P gain of 89.4%, or 11.1% a year.
But here’s the kicker: When the 10-year yield fell (4,836 days), and long-term bonds rallied, the S&P 500 gained an amazing 86,631%, or 42.5% a year.
Probably the most fascinating stat is that all of the stock market’s net capital gains have come when the 10-year yield is 65 or more basis points above the 90-day yield (that happens about 70% of the time). The yield curve hasn’t been that positive in 15 months.
Anything less than 65 basis points, including a negative yield curve, works out to a net equity return of a Blutarsky. Zero Point Zero.

Yield Curve Provides Ominous Signs

The yield curve has been the subject of an increasing amount of chatter in recent weeks, as long-term interest rates rise and short-term rates remain low.  Some stories have suggested that the curve is at record highs, but based on the official definition from the NY Fed, while the yield curve spread is extremely high, it is not quite at a record.
According to literature from the NY Fed's website, the yield curve is defined as, "the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill."  On a historical basis it has been "a valuable forecasting tool...in predicting recessions two to six quarters ahead."
Using the Fed's definition of the yield curve, the chart below shows the historical spread between the yields on the 3-month and 10-year US Treasury (in basis points).  As shown in the chart below, the current level of the yield curve is nearly two standard deviations above its historical average.  The only other time that the spread got this wide was back in August 1982.

Treasury Yields Rise as Curve Steepens

from Bloomberg:

By Cordell Eddings and Susanne Walker

Dec. 10 (Bloomberg) -- Treasuries fell, with the gap in yields between 2- and 30-year securities reaching the widest margin since at least 1980, after a $13 billion offering of 30- year bonds drew lower-than-forecast demand.

The so-called yield curve touched 373 basis points, the most in at least 29 years, as the bonds drew a yield of 4.52 percent, compared with an average forecast of 4.483 percent in a Bloomberg News survey of five of the Federal Reserve’s 18 primary dealers. The so-called yield curve has widened from 191 basis points at the end of 2008, with the Fed anchoring its target rate at a record-low range of zero to 0.25 percent and the Treasury extending the average maturity of U.S. debt.

“This was a mediocre auction where the yield needed to be tweaked a little on the high side to get it done,” said William Larkin, a fixed-income portfolio manager in Salem, Massachusetts at Cabot Money Management, which manages $500 million. “It’s an indication of what’s to come in 2010. We expect a gradual uptick to higher yields.”

The yield on the current 30-year bond rose eight basis points to 4.49 percent at 4:11 p.m. in New York, according to BGCantor Market Data. Two-year note yields increased one basis point to 0.76 percent.

Treasury officials on Nov. 4 announced a long-term target of six to seven years for the average maturity of Treasury debt and said the department wants to cut back on its issuance of bills and two- and three-year notes. The shift to longer- maturity debt has raised concern that investors will demand higher yields to offset the risk of inflation as government spending drives the deficit to a record $1.4 trillion.

‘Piling on Out’

“The curve reflects the Fed taking short-term rates as low as it can go and the Treasury piling on out the curve,” said Ward McCarthy, chief financial economist at Jefferies & Co. Inc. in New York. Jefferies is one of 18 primary dealers required to bid at Treasury auctions. “While there is a strong overseas underwriting bid for 5s, 7s and 10s, the bond overwhelmingly is a domestic issue. The slope of the curve reflects the concession necessary to attract sufficient buyers to take the issue down.”

The spread between 2- and 30-year has averaged 132 basis points over the last five years. Historically, a so-called steeper yield curve reflects diminishing demand from investors anticipating faster economic growth and inflation.

Treasury two-year note yields fell 11 basis points over the first two trading days of this week as Fed chairman Ben S. Bernanke repeated that the central bank expected an “extended period” of low rates and Fitch Ratings reduced Greece’s credit rating. The yield touched 0.69 percent on Dec. 8, a level last seen on Dec. 2, two days before it surged the most since August after a report showed the U.S. economy lost fewer jobs than forecast in November.

Unable to Absorb

“Easy monetary policy coupled with loose fiscal policy and sovereign credit concerns easily explain the steep curve,” said Brian Varga, head of U.S. Treasury bond trading in New York at Standard Chartered Plc.

The bid-to-cover ratio at today’s auction, which gauges demand by comparing total bids with the amount of securities offered, was 2.45, compared with an average of 2.38 at the last 10 auctions.

Indirect bidders, an investor class that includes foreign central banks, bought 40.2 percent of the notes at today’s auction. They purchased 44 percent at the November sale. The average for the past 10 auctions is 40.4 percent.

“As we are seeing, if foreign investors don’t step into the bidding process, then the Street is not able to absorb the debt, so concessions make it now beneficial to start participating,” said Michael Franzese, managing director and head of Treasury trading at Wunderlich Securities in New York.

$7.17 Trillion

U.S. government debt lost investors about 2 percent this year, according to Bank of America Corp.’s Merrill Lynch Treasury Master Index, as President Barack Obama borrowed record amounts to fund spending programs. U.S. marketable debt rose to a record $7.17 trillion in November.

U.S. government securities declined yesterday after an investor class that includes foreign central banks bought the least amount of 10-year notes since June at the government’s auction.

The $21 billion offering drew a yield of 3.448 percent, compared with an average forecast of 3.421 percent in a Bloomberg survey. The bid-to-cover ratio, which gauges demand, was 2.62, less than an average of 2.63 at the past 10 auctions.

Indirect bidders, which include foreign central banks, purchased 34.9 percent of the 10-year debt on offer, compared with an average of 45.6 percent since the Treasury made changes in June on how bids are classified.

The previous day’s sale of three-year notes drew a yield of 1.223 percent, compared with a forecast for 1.229 percent.

Yield Curve Steepest in Nearly 30 Years!

from Mish Shedlock:

The bond market is starting to show signs of concern over budget deficits and the corresponding supply of treasuries. Please consider Treasury Yield Curve Steepest Since at Least 1980 After Auction.

Treasuries fell, with the gap in yields between 2- and 30-year securities reaching the widest margin since at least 1980, after a $13 billion offering of 30- year bonds drew lower-than-forecast demand.

The so-called yield curve touched 372 basis points, the most in at least 29 years, as the bonds drew a yield of 4.52 percent. The so-called yield curve has widened from 191 basis points at the end of 2008, with the Fed anchoring its target rate at a record-low range of zero to 0.25 percent and the Treasury extending the average maturity of U.S. debt.

Treasury officials on Nov. 4 announced a long-term target of six to seven years for the average maturity of Treasury debt and said the department wants to cut back on its issuance of bills and two- and three-year notes. The shift to longer- maturity debt has raised concern that investors will demand higher yields to offset the risk of inflation as government spending drives the deficit to a record $1.4 trillion.

“The market is continuing to worry about the massive amount of Treasury issuance that’s going to hit the market well into next year,” said Ian Lyngen, senior government bond strategist at CRT Capital Group LLC in Stamford, Connecticut. “In the very short term, part of it is going to be supply accommodation.”

Yield Curve As Of December 10 2009



Historical Yield Curve



click on any chart in this post for sharper image

Chart Symbols
$IRX - The 3 month treasury - Brown
$FVX - The 5 year treasury - Blue
$TNX - The 10 year treasury - Orange
$TYX - The 30 year treasury - Green

A 2 year treasury symbol is not available.

The above chart shows the dramatic steepening in the yield curve since January 2009. This steepening is reflective of several things: An economy presumed to be improving but not at a very good rate, the Fed holding down short-term rates, and the huge pending supply of treasuries to finance the budget.

Judging from action in the 5-year treasury, it appears as if there is a long 3-to-5 year, short 30-year trade in play.

Even with that steep yield curve, banks are not lending judging by the plunge in consumer credit and small business loans.

Total Consumer Credit



click on chart for sharper image

Total Bank Credit



click on chart for sharper image

Total bank credit is starting to rebound but from depths never before seen.

US$ Weekly Chart



click on chart for sharper image

2010 Forecast - The Great Retrace



That segment with Aaron Task is from Mish: Nov. Jobs Report "Looked Fabricated", Expect Harder Times in 2010

From President Obama on down, Americans are hoping Friday's stronger-than-expected November jobs report marked the beginning of the end of our national unemployment nightmare. Looking beyond the November jobs data, Shedlock says the odds of the unemployment rate coming down anytime soon are remote.

As confident as he is about the grim outlook for jobs, Shedlock was very reticent to make market predictions in the accompanying video, taped Friday evening at Minyanville's annual Holiday Festivus in New York City.

In a subsequent email, Shedlock was more willing to take a position, as is more typical of the opinionated blogger:

"In the absence of a war outbreak in the Middle East or Pakistan -- and/or Congress going completely insane with more stimulus efforts -- I think oil prices are likely to drop, the dollar will strengthen or at least hold its own, and the best opportunities are likely to be on the short side," he writes. "2010 is highly likely to retrace most if not all of the ‘reflation' efforts of 2009. If things play out as I suspect, 2010 will be the year of the great retrace as the economic recovery disappoints."

If the US$ breaks North in a sustained way as it appears poised to do, and if treasury yields break higher as well (on that I have no firm opinion), 2010 is going to be one miserable year for nearly everyone.

Note that a seasonal favorable period for treasuries ends this month. Moreover, March-May is typically the worst period for government bonds because of budgeting and tax refunds. However, one should not lightly dismiss the possibility of another flight to safety play if commodities and equities head dramatically lower as I ultimately expect them to do.

Bond Vigilantes Are Back and Beating Obama's Fed

from Bloomberg:

By Liz Capo McCormick and Daniel Kruger

May 29 (Bloomberg) -- They’re back.

For the first time since another Democrat occupied the White House, investors from Beijing to Zurich are challenging a president’s attempts to revive the economy with record deficit spending. Fifteen years after forcing Bill Clinton to abandon his own stimulus plans, the so-called bond vigilantes are punishing Barack Obama for quadrupling the budget shortfall to $1.85 trillion. By driving up yields on U.S. debt, they are also threatening to derail Federal Reserve Chairman Ben S. Bernanke’s efforts to cut borrowing costs for businesses and consumers.

The 1.4-percentage-point rise in 10-year Treasury yields this year pushed interest rates on 30-year fixed mortgages to above 5 percent for the first time since before Bernanke announced on March 18 that the central bank would start printing money to buy financial assets. Treasuries have lost 5.1 percent in their worst annual start since Merrill Lynch & Co. began its Treasury Master Index in 1977.

“The bond-market vigilantes are up in arms over the outlook for the federal deficit,” said Edward Yardeni, who coined the term in 1984 to describe investors who protest monetary or fiscal policies they consider inflationary by selling bonds. He now heads Yardeni Research Inc. in Great Neck, New York. “Ten trillion dollars over the next 10 years is just an indication that Washington is really out of control and that there is no fiscal discipline whatsoever.”

Investor Dread

What bond investors dread is accelerating inflation after the government and Fed agreed to lend, spend or commit $12.8 trillion to thaw frozen credit markets and snap the longest U.S. economic slump since the 1930s. The central bank also pledged to buy as much as $300 billion of Treasuries and $1.25 trillion of bonds backed by home loans.

For the moment, at least, inflation isn’t a cause for concern. During the past 12 months, consumer prices fell 0.7 percent, the biggest decline since 1955. Excluding food and energy, prices climbed 1.9 percent from April 2008, according to the Labor Department.

Bill Gross, the co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co. and manager of the world’s largest bond fund, said all the cash flooding into the economy means inflation may accelerate to 3 percent to 4 percent in three years. The Fed’s preferred range is 1.7 percent to 2 percent.

“There’s becoming an embedded inflationary premium in the bond market that wasn’t there six months ago,” Gross said yesterday in an interview at a conference in Chicago.

Shrinking Economy

Bonds usually rally when the economy is in recession and inflation is subdued. Gross domestic product dropped at a 5.7 percent annual pace in the first quarter, after contracting at a 6.3 percent rate in the last three months of 2008, according to the Commerce Department.

This time it’s different because the Congressional Budget Office projects Obama’s spending plan will expand the deficit this year to about four times the previous record, and cause a $1.38 trillion shortfall in fiscal 2010. The U.S. will need to raise $3.25 trillion this year to finance its objectives, up from less than $1 trillion in 2008, according to Goldman Sachs Group Inc., one of 16 primary dealers of U.S. government securities that are obligated to bid at Treasury auctions.

“The deficit and funding the deficit has become front and center,” said Jim Bianco, president of Bianco Research LLC in Chicago. “The Fed is going to have to walk a fine line here and has to continue with a policy of printing money to buy Treasuries while at the same time convince the market that this isn’t going to end in tears with fits of inflation.”

‘Potential Benefits’

Ten-year note yields, which help determine rates on everything from mortgages to corporate bonds, rose as much as 1.71 percentage points from a record low of 2.035 percent on Dec. 18. That was two days after the Fed said it was “evaluating the potential benefits of purchasing longer-term Treasury securities” as a way to keep consumer borrowing costs from rising.

The yield on the 10-year note rose one basis point, or 0.01 percentage point, to 3.47 percent this week, according to BGCantor Market Data. The price of the 3.125 percent security maturing in May 2019 fell 3/32, or 94 cents per $1,000 face amount, to 97 4/32. The yield touched 3.748 percent yesterday, the highest since November.

The dollar has also begun to weaken against the majority of the world’s most actively traded currencies on concern about the value of U.S. assets. The dollar touched $1.4169 per euro today, the weakest level this year.

Bond Intimidation

Ten-year yields climbed from 5.2 percent in October 1993, about a year after Clinton was elected, to just over 8 percent in November 1994. Clinton then adopted policies to reduce the deficit, resulting in sustained economic growth that generated surpluses from his last four budgets and helped push the 10-year yield down to about 4 percent by November 1998.

Clinton political adviser James Carville said at the time that “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

The surpluses of the Clinton administration turned into record deficits as George W. Bush ramped up spending, including financing of the wars in Iraq and Afghanistan.

The bond vigilantes are being led by international investors, who own about 51 percent of the $6.36 trillion in marketable Treasuries outstanding, up from 35 percent in 2000, according to data compiled by the Treasury.

New Group

“The vigilante group is different this time around,” said Mark MacQueen, a partner and money manager at Austin, Texas- based Sage Advisory Services Ltd., which oversees $7.5 billion. “It’s major foreign creditors. This whole idea that we need to spend our way out of our problems is being questioned.”

MacQueen, who started in the bond business in 1981 at Merrill Lynch, has been selling Treasuries and moving into corporate and inflation-protected debt for the last few months.

Chinese Premier Wen Jiabao said in March that China was “worried” about its $767.9 billion investment and was looking for government assurances that the value of its holdings would be protected.

The nation bought $5.6 billion in bills and sold $964 million in U.S. notes and bonds in February, according to Treasury data released April 15. It was the first time since November that China purchased more securities due in a year or less than longer-maturity debt.

Obama’s Confidence

Treasury Secretary Timothy Geithner, who will travel to Beijing next week, will encourage China to boost domestic demand and maintain flexible markets, a Treasury spokesman said yesterday.

Obama spokesman Robert Gibbs said the president is confident that his budget and economic plans will cut the deficit and bring down the nation’s debt.

“The president feels very comfortable with the steps that the administration is taking to get our fiscal house in order and understands how important it is for our long-term growth,” Gibbs said.

Investors are also selling Treasuries as the economy shows signs of bottoming and credit and stock markets rebound, lessening the need for the relative safety of government debt. And while yields are rising, they are still below the average of 6.49 percent over the past 25 years.

‘Renewed Appreciation’

The world’s largest economy will begin to expand next quarter, according to 74 percent of economists in a National Association for Business Economics survey released this week. The Standard & Poor’s 500 has risen 36 percent since bottoming on March 9, while the London interbank offered rate, or Libor, that banks say they charge each other for three-month loans, fell to 0.66 percent today from 4.819 percent in October, according to the British Bankers’ Association.

Three-month Treasury bill rates have climbed to 0.13 percent after falling to minus 0.04 percent Dec. 4. That flight to safety helped U.S. debt rally 14 percent in 2008, the best year since gaining 18.5 percent in 1995, Merrill indexes show.

“Yes there’s been a big move, and you can argue the big move is driven by the renewed appreciation of the risks associated with holding long-term Treasury bonds,” said Brad Setser, a fellow for geoeconomics at the Council on Foreign Relations in New York.

Fed officials see several possible explanations for the rise in yields beyond investor concern about inflation. Among them: The supply of Treasuries for sale exceeds the Fed’s $300 billion purchase program, the economic outlook is improving and investors are selling government debt used as a hedge against mortgage securities.

Liquidity

Central bankers want to avoid appearing to react solely to market swings. Bernanke hasn’t formally asked policy makers to consider whether to increase Treasury purchases and may not do so before the Federal Open Market Committee’s next scheduled meeting June 23-24. Officials are confident they can mop up liquidity without gaining additional tools from Congress, such as the ability for the Fed to issue its own debt.

The Fed declined to comment for the story. Bernanke has an opportunity to discuss his views when he testifies June 3 before the House Budget Committee in Washington.

“We have daily reminders from bond vigilantes like Bill Gross about the prospect of losing our AAA rating,” Federal Reserve Bank of Dallas President Richard Fisher said in Washington yesterday. “This cannot be allowed to happen.”

Repair the Damage

The government and Fed are trying to repair the damage from the collapse of the subprime mortgage market in 2007, which caused credit markets to freeze, led to the collapse of Lehman Brothers Holdings Inc. in September and was responsible for $1.47 trillion of writedowns and losses at the world’s largest financial institutions, according to data compiled by Bloomberg.

The initial progress Bernanke made toward reducing the relative cost of credit is in jeopardy of being unwound by the work of the bond vigilantes.

The average rate on a typical 30-year fixed mortgage rose to 5.08 percent this week from 4.85 percent in April, according to North Palm Beach, Florida-based Bankrate.com. Credit card rates average 10.5 percentage points more than 1-month Libor, up from 7.19 percentage points in October.

“Longer term the danger is that the rise in yields disrupts the recovery or the rise in inflation expectations dislodges the Fed’s current complacency on inflation,” Credit Suisse Group AG interest-rate strategists Dominic Konstam, Carl Lantz and Michael Chang wrote in a May 22 report.

‘It’s Over’

Inflation expectations may best be reflected in the yield curve, or the difference between short- and long-term Treasury rates. The gap widened this week to 2.76 percentage points, surpassing the previous record of 2.74 percentage points set on Aug. 13, 2003. Investors typically demand higher yields on longer-maturity debt when inflation, which erodes the value of fixed-income payments, accelerates.

“The yield spreads opening up imply that inflation premiums are rising,” said former Fed Chairman Alan Greenspan in a telephone interview from Washington on May 22. “If we try to do too much, too soon, we will end up with higher real long- term interest rates which will thwart the economic recovery.”

Other economists are more pointed. After falling from 16 percent in the early 1980s, 10-year yields have nowhere to go but up, according to Richard Hoey, the New York-based chief economist at Bank of New York Mellon Corp.

“The secular bull market in Treasury bonds is over,” Hoey said in a Bloomberg Television interview. “It ran a good 28 years. They’re never going lower. That’s it. It’s over.”

Is the Bubble About to Burst?

from Atlantic Business:
It's extremely easy to get very deep in the weeds very quickly when talking about what's happening in the market for government bonds. "Steepening yield curve," is one of those signal phrases that informs 99% of the population that what follows will be intelligible or uninteresting, or both. But recent moves in the market for government debt have exercised insiders. Across the Curve's John Jansen got the blogosphere's attention, for instance, by writing:

Maybe the final climactic event is upon us. Maybe the final bubble to burst is the US Treasury market and maybe we are on the verge of a financial Krakatoa which will realign financial markets.

Whatever the case it feels like the calm before the storm and we are about to embark on another interesting expedition.

Ok, then. Best to try and figure out what's going on.

Very basically, the government is having a much easier time selling short duration debt than it is long duration debt. Both central banks and private investors are piling into shorter maturity bills and notes. The question is why. Potential explanations include waning interest from buyers who were seeking safety but who now feel comfortable buying things other than government debt, and investors nervous about repayment prospects. The main factor is related to both of these explanations -- investors are anticipating a recovery, and are anticipating that recovery will bring inflation.

Those expectations mean that interest in longer maturity bonds will decline until rates on those bonds rise; investors need to be compensated for the expected deterioration in the value of the dollar over the life of the instrument. The downside here is that the Fed has tried very hard to keep long-term interest rates low in order to increase investment and juice the economy, and the rise in long-term rates is pushing up the cost of things like 30-year mortgages. On the other hand, a little inflation and dollar depreciation would be healthy for the economy, provided that it didn't lead to a damaging spike in commodity prices.

But the real silver lining to the steepening yield curve is the effect on the banking industry. It certainly looks like we're committed to propping troubled banks up while they attempt to earn their way out of this mess, and a steep yield curve is good for bank earnings. So, you know, bright side!

Yield Curve Steepening

from Mish's Global Economic Analysis:
Bernanke cannot have his cake and eat it too. If the economy is recovering the yield curve should steepen. And steepen it has. The Yield Curve Is Steepest On Record.

The difference in yields between Treasury two and 10-year notes widened to a record on concern surging sales of U.S. debt will overwhelm the Federal Reserve’s efforts to keep borrowing costs low.

The so-called yield curve steepened to 2.75 percentage points, surpassing the previous record of 2.74 percentage points set on Aug. 13, 2003.

Ten-year notes have lost 10.3 percent this year, according to Merrill Lynch & Co. indexes, while 30-year bonds have lost 27.5 percent. Two-year notes have gained 0.2 percent...

If the economy is recovering, the Fed should welcome this steepening. However, what if the yield curve is simply reacting at the thought of Bernanke monetizing Obama's massive deficits and the various stimulus plans?

I doubt the economy is recovering but it is may be getting worse at a lesser rate. Moreover, if the curve flattens, it sure will not be because of intervention, it will be because the so-called recovery has stalled. Heaven help Bernanke if the economy worsens and the yield curve continues to steepen.

Regardless why the yield curve is steepening, Bernanke's belief that he can control both the long and short end of the curve is seriously misguided. The fact is he cannot really control either, at least for long.