Friday, August 16, 2019

Yield Curve Inverts: Head for the Hills?

The stock market tanked on Wednesday, August 14 because the yield spread between the 10-year US Treasury bond and the 2-year Treasury note turned negative. Such an inversion of the yield curve is widely viewed as a reliable leading indicator of economic recessions. In fact, it is one of the 10 components of the Index of Leading Economic Indicators. But so is the S&P 500, which remains close to its recent high but would fall sharply if stock investors become convinced that a recession is imminent.

Not only did the stock market react badly to the latest yield-curve inversion, but so did President Donald Trump, who tweeted: "CRAZY INVERTED YIELD CURVE! We should easily be reaping big Rewards & Gains, but the Fed is holding us back."

An inverted yield curve has predicted 10 of the last 7 recessions. In other words, it isn't as accurate a predictor of economic downturns as widely believed. It can be misleading.

In our recently published study "The Yield Curve: What Is It Really Predicting?," we concluded that inverted yield curves do not cause recessions. In the past, they’ve predicted credit crunches caused by Fed tightening. So investors on the lookout for a recession should instead pay attention to credit availability. Recession-watchers should keep an eye on bank credit metrics—specifically, net interest margin, charge-offs and dividends, and business loans. Right now, those metrics aren’t signaling a credit crunch. In our study, we observed:

“One widely held view is that banks stop lending when the rates they pay in the money markets on their deposits and their borrowings exceed the rates they charge on the loans they make to businesses and households. So an inverted yield curve heralds a credit crunch, which inevitably causes a recession. …The widely held notion that a flat or an inverted yield curve causes banks to stop lending doesn’t make much sense. The net interest margin, which is reported quarterly by the Federal Deposit Insurance Corporation (FDIC), has been solidly positive for banks since the start of the data in 1984.”

Credit remains amply available. The Fed has been back in easing mode since the end of July, when the federal funds rate was cut by 25bps. Fed officials are likely to respond to the inversion with more rate cuts.

Our study includes a “Primer on the Yield Curve,” based on “Dr. Ed’s” book Predicting the Markets (2018). It also includes several useful charts for gleaning more insights into the relationships of the yield curve to the economy and to financial markets.

Monday, August 5, 2019

The Great Inflation Delusion

The Fed, the European Central Bank (ECB), and the Bank of Japan (BOJ) came up with lots of headline-grabbing shock-and-awe programs over the past 10 years in reaction to the Great Financial Crisis. Over time, they seemed to lose their effectiveness and ability to shock or awe.

Nevertheless, the US economy had improved sufficiently by 2014 that the Fed terminated Quantitative Easing (QE) in October 2014 and started very gradually to raise interest rates in late 2015. However, by the end of July 2019, the Fed was lowering the federal funds rate again. The ECB terminated its QE at the end of 2018 and was expecting to raise interest rates by mid-2019. However, by July 2019, the ECB signaled that it would most likely lower its deposit rate further into negative territory in September, and that more QE might be ahead. The BOJ has yet to even consider normalizing monetary policy, and continues to expand its balance sheet. By the summer of 2019, the major central banks seem to have run out of new tricks.

The central bankers have been fighting powerful forces of deflation. With all the liquidity they’ve provided, they have succeeded in averting outright deflation. However, the Fed, the ECB, and the BOJ haven’t succeeded in pushing inflation in their countries up to their 2.0% targets. Inflation remains awfully close to zero and too close to its border with deflation.

In my opinion, the central bankers are trying to fix problems that can’t be fixed with ultra-easy monetary policies. They are trying to fight the four forces of deflation: Détente, Disruption, Debt, and Demographics. I call them the deflationary “4Ds.” Let me explain:

Détente. Détente occurs after wars. Such periods of peacetime lead to globalization with freer trade, which means more global competition in markets for labor, capital, goods, and services. Wars, in effect, are trade barriers. The end of the Cold War marked the beginning of the current period of globalization.

Competition is inherently deflationary. No one can raise their price in a competitive market because it is capped by the intersection of aggregate supply and demand. However, anyone can lower their price if they can cut their costs by boosting productivity. The incentives to do so are great because that’s a sure way to increase market share and profits.

History shows that prices tend to rise rapidly during wartime and then to fall during peacetime. War is inflationary; peace is deflationary. The CPI for the US is available since 1800. It spiked sharply during the War of 1812, the Civil War, World War I, and World War II. During peacetimes, prices fell sharply for many years following all the wars listed above, except for the peace so far since the end of the Cold War in 1989. (Of course, there have been local wars since then, and all too many terrorist attacks, but none that has substantially disrupted commerce.) Prices still are rising in the United States, though at a significantly slower pace than when the Cold War was most intense.

During wartimes, global markets are fragmented. Countries don’t trade with their enemies. They face military obstacles to trading with their allies and friends. Commodity prices tend to soar as the combatants scramble to obtain the raw materials needed for the war effort. A significant portion of the labor force has been drafted and is in the trenches. The upward pressure on labor costs and prices often is met with government-imposed wage and price controls that rarely work. Entrepreneurs, engineers, and scientists are recruited by the government to win the war by designing more effective and lethal weapons.

Peacetimes tend to be deflationary because freer trade in an expanding global marketplace increases competition among producers. Domestic producers no longer are protected by wartime restrictions on both domestic and foreign competitors. There are fewer geographic limits to trade and no serious military impediments. Economists mostly agree that the fewer restrictions on trade and the bigger the market, the lower the prices paid by consumers and the better the quality of the goods and services offered by producers. These beneficial results occur thanks to the powerful forces unleashed by global competition during peacetimes.

As more consumers become accessible around the world, more producers around the world seek them out by offering them competitively priced goods and services of better and better quality. Entrepreneurs have a greater incentive to research and develop new technologies in big markets than in small ones. The engineers and scientists who were employed in the war industry are hired by companies scrambling to meet the demand of peacetime economies around the world. Big markets permit a greater division of labor and more specialization, which is conducive to technological innovation and productivity.

My war-and-peace model of inflation simply globalizes the model of perfect competition found in the microeconomic textbooks. The single most important characteristic of this microeconomic model is that there are no barriers to market entry. Anyone can start a business in any industry. In addition, there are no protections against failure. Unprofitable firms restructure their operations, get sold, or go out of business. There are no “zombies,” i.e., living-dead firms that continue to produce even though they are bleeding cash. They should go out of business and be buried. These firms can only survive if they are kept on life support by government subsidies, usually because of political cronyism.

The microeconomic model of perfect competition predicts that the market price will equal the marginal cost of production. An increase in demand might temporarily increase profits, but that would stimulate more production among current competitors and attract new market entrants. If demand drops such that losses are incurred, competitors will cut production, with some possibly shutting down if the decline in demand is permanent. New entrants certainly won’t be attracted.

So no one firm or group of firms can set the price. Both producers and consumers are “price-takers.” No one has enough clout in the market to dictate the price that everyone must receive or pay. The price is set by the “invisible auctioneer,” who equates total market demand to total supply at the market’s equilibrium price, which is determined by the marginal cost of production.

Profits are reduced to the lowest level that provides just enough incentive for enough suppliers to stay in business to satisfy demand at the going market price. Consumer welfare is maximized. Obviously, there can’t be excessive returns to producers in a competitive market. If there are, those returns will be eliminated as new firms flood into the excessively profitable market. Firms that try to increase their profits by raising prices simply will lose market share to firms that adhere to the market price. That’s a good way to go out of business.

This microeconomic textbook model of perfect competition seems to be much more relevant in explaining deflation and disinflation during periods of globalization than any macro model. Globally, there have been fewer barriers to market entry because of the end of the Cold War. This is certainly true geographically. It is also true in other ways. For example, a potential barrier to entry in some industries is the availability of financing. Technology is especially dependent on venture capital. Low interest rates and booming stock markets around the world since the early 1990s provided plenty of cheap capital—too much, in some cases.

Disruption. Competitive markets facing worker shortages will tend to stimulate productivity via technological innovation. Technology is inherently disruptive across a wide range of businesses. That’s all very deflationary. Clearly, there is a tremendous incentive to innovate and use technology to lower costs. Firms that do so gain a competitive advantage that allows them to have a higher profit margin for a while. That’s especially true if their advantage is sufficiently significant to put competitors out of business. However, some of their competitors undoubtedly will innovate as well, and there is always the possibility of new entrants arriving on the scene with innovations that pose unexpected challenges to the established players.

Debt. The forces of deflation that had been mounting since the end of the Cold War were held back by rapid credit expansion around the world. Central banks were lulled by the decline in inflation and the proliferation of prosperity following the end of the Cold War into believing that they had moderated the business cycle. Indeed, they attributed this achievement to their policies rather than to globalization, and they dubbed it the “Great Moderation”—which presumably started during the mid-1980s but ended abruptly with the “Great Recession” in 2008. So they provided lots of cheap credit and enabled lots of borrowing by households, businesses, and governments.

The central bankers simply ignored the implications of soaring debt. Their macroeconomic models didn’t give much, if any, weight to measures of debt. Perversely, their easy monetary policies reduced the burden of servicing previous debts, which could be refinanced at lower rates, allowing borrowers to borrow more. By declaring that they had moderated the business cycle, the central bankers encouraged debtors to be less cautious about the potential dangers of too much leverage.

Around the world, governments borrowed like there was no tomorrow. In the United States, buyers bought homes with no money down and “liars’ loans,” where credit was granted without a formal credit check. In the Eurozone, banks lent to borrowers in Portugal, Ireland, Italy, Greece, and Spain (the “PIIGS”) as though they had the same credit ratings as German borrowers. That turned out to be a very bad assumption. Emerging market economies likewise could borrow on favorable terms despite their often spotty credit histories.

These credit excesses all hit the fan in 2008, and the consequences were clearly deflationary. The Great Moderation turned into the Great Recession. To avert another Great Depression, the central banks of the major industrial economies scrambled to flood the financial markets with credit. So far, their ultra-easy monetary policies have succeeded in offsetting the natural, peacetime forces of deflation. Of course, central bankers existed in the past when deflation prevailed but monetary theory and operating procedures were primitive. Today’s central bankers claim that this all proves they are better than ever at managing the economy with monetary policy. I hope they’re right, but I’m not convinced.

Demography. Demographic profiles are turning increasingly geriatric around the world. People are living longer. They are having fewer children. As a result of widespread urbanization, children no longer provide the benefit of labor in rural economies. Instead, they are a significant cost in urban settings. Economies with aging demographic trends are likely to grow more slowly and have less inflation.

Governments with aging populations are bound to borrow more. Governments challenged by rising dependence ratios—with the number of retiring seniors outpacing the number of young adult workers—don’t have much choice but to borrow money to meet their funding gaps. Debt accumulated for this purpose is likely to weigh on economic growth rather than to stimulate it.

The 4Ds combined tend to weigh on economic growth and are inherently deflationary. This explains why unconventional ultra-easy monetary policies have become conventional over the past 10 years. The central bankers are doing more of the same and getting the same disappointing result. Like Sisyphus of ancient Greek mythology, every time they push the boulder up the hill, it comes rolling back down.

Central bankers tend to be macroeconomists who were taught in graduate school that inflation is a monetary phenomenon. They were also taught to hate deflation as much as inflation. That’s why the major central banks have all pegged 2.0% as their Goldilocks inflation target, not too hotly inflationary or frigidly deflationary.

But surely, they must have learned over the past 10 years that inflation isn’t a monetary phenomenon after all. They must realize that the four powerful forces of deflation are microeconomic in nature.

In a speech in July 16 speech in Paris, Fed Chair Jerome Powell acknowledged in passing that inflation may not be solely a monetary phenomenon: “Many factors are contributing to these changes—well-anchored inflation expectations in the context of improved monetary policy, demographics, globalization, slower productivity growth, greater demand for safe assets, and weaker links between unemployment and inflation. And these factors seem likely to persist.”

He also acknowledged that these factors collectively may continue to keep the “neutral rate of interest low,” i.e., too close to zero, which is the dreaded “effective lower bound.” He concluded: “This proximity to the lower bound poses new complications for central banks and calls for new ideas.”

The problem is that the central bankers have run out of new ideas (and policy tools), so they keep trying the same old ones. Their delusion is that doing more of the same (i.e., ultra-easy monetary policy) should boost inflation to 2.0%. Maybe they should just give up on the notion that deflation is a bad outcome of the 4Ds and admit that they are trying to fix a problem that monetary policy cannot fix.

If they persist in their delusion and their ultra-easy monetary policies, the outcome will continue to be asset price inflation, especially in global equity markets. That’s fine, until it isn’t.