Posts Tagged yield curve
On January 18, real yields turned positive on 10-year TIPS. Markets are possibly getting a bit more optimistic. Here are a couple of representative real yield curves. Essentially, during the last week the real yield curve shifted up about 14 basis points. (To get the complete data in an Excel 2007 workbook, click here.)
Nominal yields shifted up about 19 basis points in the longer maturities. Thus there was an increase in inflation expectations of about 5 basis points.
We can easily construct an inflation expectations curve. Expected inflation is simply the difference between the nominal and real interest rate for each maturity. Here’s what it looks like:
Well, the FOMC didn’t call it QE3, but it’s pretty close. For those with short memories, QE1 and 2 were the “quantitative easing” programs in which the Fed purchased large quantities of non-traditional securities, including U.S. government bonds and mortgage-backed securities. After Wednesday’s FOMC meeting, Ben Bernanke announced that the Fed would take another shot at “operation twist.” What they’re trying to twist is the yield curve. But they don’t want to add to inflationary pressures, so they need to keep the money supply relatively constant.
And what they’re proposing may work. The Fed will sell $400 billion of Treasury bills and other short-term government debt. At the same time they will purchase $400 billion of ten year U.S. government bonds. Net change in the money supply: $0. The idea is that the increased demand for long-term bonds will push the price up and the interest rate down. Other long-term rates (mortgages, corporate bonds, maybe even longer-term municipal bonds) should also see their yields fall. Lower borrowing costs will probably induce a bit more borrowing in the long-term debt markets.
Parenthetically, I have to wonder about the three FOMC members who voted against this. In the past their dissent has been based on fears of inflation. But this new policy does not change the money supply. That should have eased their concerns, but apparently did not. We’ll see what the markets say. If long-term interest rates drop, the Fed’s policy has worked. However, it’s also possible that inflation expectations might rise, causing those same interest rates to rise. Watch the behavior of those long-term rates carefully over the next few weeks.
Is it enough to fix the U.S. economy? No way. Long-term interest rates are already very low. According to the Wall Street Journal, AA corporate bond yields have varied between 2.60 and 3.44% over the last year. As of 1 pm Pacific Time, the yield was 2.91%. Companies like Microsoft and Google that have traditionally shunned debt have issued billions of dollars in long-term bonds to take advantage of this situation. The problem is not interest rates. The problem is a lack of aggregate demand. And aggregate demand won’t recover until the unemployment rate falls considerably. I’ve argued elsewhere that the unemployment rate will remain high until some of the regulatory uncertainty emanating from Washington, D.C. is resolved.
The Fed is doing everything they can. But monetary policy really is like pushing on a string. Without demand pulling at the other end of the string, it won’t move much. Neither will the economy.
Fed chairman Ben Bernanke and the FOMC announced a new round of “quantitative easing” on November 3. Some of us are old enough to remember when QE2 was the abbreviation for a luxury ocean liner (the Queen Elizabeth II, still owned and operated by Cunard). Today those initials have been co-opted by the Fed to stand for the second round of quantitative easing.
The idea here is simple enough. Banks are not lending their excess reserves. In fact, the Fed’s latest H3 report includes the following information:
So instead of just buying more short-term Treasury securities (and expanding the excess reserve base even more), the Fed has decided to make purchases of longer-term Treasury notes and bonds. In fact, $600 billion in new purchases, at a rate of $75 billion per month for eight months. The Fed has repeatedly stated that their concern is deflation. They are deliberately trying to create inflation. Here’s an excerpt from their November 3 press release: “Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.”
So what’s the problem? Apparently some folks don’t understand the yield curve. This is straight out of the Wall Street Journal article:
Since August 27, yields on T-notes (maturities between 1 and 10 years) have fallen. However, T-bond yields have risen. It seems clear to me that the Fed has pretty much succeeded. Long-term yields are higher because the Fed has managed to increase inflation expectations. Note, however, that inflation expectations have only risen beyond the 10 year horizon. Up to 10 years, yields have fallen, indicating that the market pretty much agrees with the Fed: inflation expectations are lower. (Of course, it’s possible that adding $600 billion in liquidity to this market has lowered relatively short-term yields simply because of expectations of more liquidity.)
What we don’t need is stuff like this:
“… David Ader, head of government-bond strategy at CRT Capital LLC, said … ‘I think the bulk of the move is a position unwind exacerbated by the timing of the year’ …” “Position unwind?” Great.