200905.29
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More on the Yield Curve

Tim Duy has a long post on the yield curve and the recent rise in long term interest rates. I covered a lot of the same ground in three separate posts (see here, here and here) yesterday, but Mr. Duy puts all the pieces together in one unified post:

So we are stuck with two apparently contrasting views. On one hand, rising long rates and the related steepening of the yield curve should indicate improving economic conditions – after all, rising yields simply imply that market participants are gaining confidence to put their money to work in more risky endeavors. The steeper yield curve should boost bank earnings and, in time, encourage lending. On the other hand, higher yields may undermine support for the housing market, thus extending the downturn.

It seems likely that there are elements of both sentiments at work here. The economy is improving from its dreadful performance of the last two quarters, but the recent rise in rates will extend the time it takes to recover to trend growth. That’s something that I argued way back when the stimulus was being debated; Keynesian spending raises interest rates in the short term because the market adjusts to the expected deficits and the spending takes a long time to kick in. Keynesian stimulus spending plans can reduce the depth of the recession but since there is no such thing as a free lunch, it can only do so by extending the duration of the recession. That may be a trade-off that many are willing to make, but it is dishonest to imply that there is no cost involved.

From Duy’s bullet points at the end of the post:

The wide US output gap suggests there is plenty of room for monetary and fiscal stimulus to operate without triggering higher interest rates. Yet rates have moved higher, and while I can’t say that 3.7%, or even 4.7%, or even 5.7%, would be surprising given the pace of Treasury issuance, the rapidity and direction of the move should give one pause - especially given the likelihood of prolonged US economic weakness. The rate increase should give policymakers pause, too.

I’m sick of hearing about the output gap, the difference between current growth and potential growth. Anyone who lived through the 1970s can tell you that inflation has nothing to do with some alleged output gap. All Keynesians repeat after me: Inflation is a monetary phenomenon. It has nothing to do with growth or lack thereof. And yes, the rapid rise in rates should give one pause. If it is primarily about fear of inflation, as I suspect, then it isn’t good news.

The continued existence of the current account deficit suggests the US remains dependent on capital inflows. To be sure, the need is not as great as a year ago, but significant nonetheless. Failure to attract those inflows would trigger downward pressure on bonds and Dollars.

Yes, the US is dependent on capital inflows. That’s what happens when you spend more than you produce. That problem can be solved in one of two ways. We can destroy our currency and have fiscal discipline imposed from outside or we can become more responsible about our spending on our own. The current account deficit is a function of the lack of US savings and at this point that is a function of the government budget deficit since the average American has finally decided to save again. This problem existed prior to the Obama administration and it will persist until it reaches a breaking point and the dollar finally succumbs.

Downward pressure on the Dollar, in addition to the liquidity provided by central bank reserve accumulation, should put upward pressure on commodities. This is particularly evident in oil prices. This will increase headline inflation, and with it inflation expectations among the general public.

Yep, that’s why I’ve been raising our exposure to commodities.

US labor market weakness appears inconsistent with a sustainable inflation dynamic; thus, rising oil prices simply cut into domestic demand. Thus, the Fed will be inclined to hold policy steady, rather than exacerbating oil driven weakness by tightening. Tightening policy would also reverse the evolving stability in financial markets and threaten a new credit crunch. And given the Fed’s willingness to accept a benign view of the yield increase, they are not likely to increase Treasury purchases. Policy on hold. This may again have the side effect of putting relentless downward pressure on the Dollar.

Okay, one more time. Inflation has nothing to do with the labor market. Ask anyone who has lived in any of the Latin American economies of the last 50 years. I have no doubt that Fed policy is on hold; there is no way they can tighten right now given the political environment. And yes, printing massive amounts of a currency will tend to depress its value.

Duy’s conclusion:

Bottom Line: I want to believe that the rapid reversal of Treasury yields is a benign, even positive, event. This is likely the Fed’s view; consequently, the will hold steady on policy. Challenging this benign view is that the reversal appears to be lock step with a return to dynamics seen in 2007 and 2008 – exceedingly low US rates encouraging Dollar outflows, stepping up the pace of foreign central bank reserve accumulation and putting upward pressure on key commodity prices. I worry that policymakers have forgotten the external dynamic that was hidden by the crisis induced flight to Dollars last fall. Indeed, capital outflows (indicated by a foreign central bank effort to reverse those flows) would signal that much work still needs to be done to curtail US consumption to bring the global economy back into balance. Policymakers are unprepared for this possibility.

The return to the status quo is what the Fed wants and so, no, I don’t think they’ll change policy. We only have two choices in how we address our debt problem: we either inflate it away or we act responsibly and reduce the debt through a combination of lower consumption and default. Taking the latter course is honest and would likely be over sooner, but the short term economic pain would be greater. The former course of inflation is dishonest and the consequences take longer to be realized, but it gets the politicians through the next election cycle. The political class always chooses inflation.

The consequences for taking on so much debt are inevitable. The only question is whether we want to take our medicine voluntarily now or have it forced on us later.