More on debt

In my previous posts I have frequently discussed government debt and the dangers it causes, but with fairly vague notions of where it becomes dangerous.  Looking further into this I have sketched out a basic outline for myself, and it follows.

1.  To steal from Adam Smith, there is an awful lot of ruin in a nation.   A country can absorb a tremendous amount of debt and spending without a collapse, and even in some cases with continued growth.  Greece hit 100% debt to gdp levels in 1994, but didn't have (perhaps thanks to some fraud) major issues until the world started shaking in 2008, and I discussed Japan as an example in my most recent post.   This is not to say that these countries were trouble free, only that the high debt loads looked more like a hindrance than a potentially fatal flaw.

2.  High debt levels can exist for long periods of time, and so are "slow moving" crisis in that sense, but the end is very fast.  The indicators that a country is approaching a crisis appear to likewise be slow moving for long stretches.

One rule of thumb that looks solid is a lack of improvement in debt to gdp levels during good times.  Greece had decent growth from 1994 through 2008, but debt to GDP levels stuck at between 98% and 110% of GDP during that time.  Think of it this way, if you left college with $50,000 in unsecured debt and started out making $50,000 a year and 10 years later you were making $100,000 a year but your unsecured (ie no mortgages) debt had also increased to $100,000 that would be a pretty bad sign for your finances, right?  What are the odds you are going to on net be paying down debt in the future if you can't even maintain a level of debt while doubling your income?  What are the odds you would be able to handle a major life crisis if your baseline is increasing debt?  Japan also had some significant warning signs during the 80s.  Their debt to GDP levels rose from 50% in 1980 to 70% in 1992 despite GDP tripling in that time.  

This is very worrying for the near future as the US has been following this pattern.  Debt to GDP was fairly stable at around 60% for the 90s and 2000s until 2008, during a period of relatively strong growth and then saw a large burst during and immediately following the crisis.  While the expansion has slowed it has not reversed with a return to full employment, debt to GDP was higher in 2017 than any year prior to 2016.  

This is a pattern not isolated to the US, I looked at 19 countries (why not 20?  because that would have been more) including most of the top 20 world economies in terms of GDP and 16 of the 19 had increased their debt to GDP levels from 2008 to 2017 and 14 of them from 2012 to 2017.  10 countries had increased debt by 20 percent of GDP or more and 5 by 30 percent or more since 2008.

This is also not a series of small economies along with the US, 6 countries from that sample now have debt to GDP ratios of 85% or more and they are the UK, Canada, France, the US, Italy and Japan.  

Concepts From Japan

Government debt to GDP is a tricky subject to discuss these days, largely because Japan with its extreme, and growing, debt loads kind of broke a lot of people's (including mine) intuitions about debt.  The lunatic fringe of economics (MMT) likes to nod toward Japan as an example of how debt doesn't matter as long as you can print your own currency, but they don't want to nod to much as it brings up the obvious questions about their growth and how, just perhaps, avoiding collapse isn't a good enough metric on its own.  Monetarists were really excited about Japan for about a quarter or two when they promised really hard to raise inflation, and managed to do it (with a large tax increase) for brief period, and Keynesians had to repeat the adage of "they didn't stimulate enough" so many times even they appear tired of it. 

Japan is a great example of one major impact of high debt loads, you get boxed in on one path, or boxed out of others.  The old debt concept that since a government liability is someone else's asset they must cancel out only works on the balance sheet.  With a debt to GDP ratio of 250% these days and government spending at around 40% of GDP interest rates of 16% would engulf the entire budget.  This is an extreme and ultimately meaningless example in a lot of ways, interest rates are no where near 16%, Japan doesn't roll over its bonds annually, etc.  The idea is not to note THE point where their government would 100% go bankrupt, but to note how much lower the point is now than it was 10, 20 and 25 years ago.  In 2008 debt to GDP was around 190%, and a (potential) budget of 40% of GDP meant that Japan could not pay more than a 21% interest rate, and in 1996/97 when it was 100% it was a 40% rate, and their pre debt explosion levels it would have been between 55 and 60%. 

In less than 30 years Japan has gone from definite ruin at levels rarely seen (only under hyperinflation) only under to levels seen in the 1970s into the early 1980s in many countries.   It is of course unlikely that they would stave off ruin until these levels were hit, interest rates of even 5 percent now across all of their debt would be very difficult to handle and would mean effectively shifting about 10% of GDP worth of spending away from current programs to interest payments, which would have a lot of impact across the economy. 

So does high debt cause low growth or does low growth cause the high debt?  The obvious answer is yes.  Both occur.  Once high debt is in place it is very difficult to get high growth, even if you have long dated bonds where the government will have years of cushion to reduce debt levels before the payments become a problem the bondholders will be taking real losses.  If those bonds are held by citizens and corporations then those losses should be a real drag on the economy.  If interest rates tracked growth perfectly (they don't, but its a starting point) then debt levels 100% of GDP would mean functionally all increases in growth would be offset by decreases in wealth held by the public.  The reverse, perversely, might be true as well.  Declining growth would mean declining interest rates, which would push the value of debt up as long as it wasn't perceived to increase the likelihood of default. 

Why do I say perversely above?  Aren't these stabilizing forces?  I don't think that they are, I see them as channeling forces, as the economy can't handle anything outside the norm well, be it growth or contraction, and so the potential pathway of the economy narrows effectively removing the dynamic segments of the markets. 

Some countries have managed to reduce large debt loads while breaking out of a potential channel, the US after WW2 is one good example, but if you look at what it took overall it is daunting.  Federal spending was slashed by 40% in year 1 after the war, then another 40% in year 2 and another 10% in year 3, the economy was effectively heavily liberalized as inhibiting regulations (price controls and the like) were removed and perpetual destruction of capital in the form of war losses were cut out, and the Federal Reserve did its bit to, keeping rates low for years after the war (and possibly causing the stagflation of the 70s along the way... possibly).

Greece is a good (as in terrible) example of how badly this type of channeling can go, the government got to a point where outside funding was necessary very early on which allowed the scenario where those outside forces could dictate Greek policy.  Now the Greeks weren't doing a bang up job managing themselves but this functionally cut out some of the possible routes out of the crisis.  A dedicated public servant pitching a plan to restore economic growth had a double hurdle to overcome, convincing both the public of his plan and external lenders.  There is a general truism here, the fewer options you have the more likely that all of them are going to be bad. 

Slow growth

Several accounts off the Great Recession talk about higher demand for money being a driving force, I don't see it.  I see it as reactionary to another force.

Sure you can make a case that the recession drove up the demand for more savings, but coincidence doesn't work so well when there are potential causal factors shifting a quarter or two prior.

In my previous post I noted that sales declined first, with layoffs not starting at unusual rates until late 2008, with the implication being that the rise in UE rate in late 2007 through mid 2008 was primarily caused by a lack of new job creation, not layoffs.   

The Federal debt ramp up has been stunning and barely commented on for its magnitude, it has risen by a larger share of GDP in the years after the end of the recession that it did during the recession.  We have not seen a sustained decline since the end of the 1990s, and there is only one sustained decline in Federal debt as a share of gdp sine 1980, making 33 of the past 38 years either flat or increasing debt to GDP.  The most worrying is the past decade plus now where the deficit has exceeded GDP growth every single year.  This is a large phase shift from the post WW2 economy where such years were rare, occurring only 3 times from 1948 through 1970, with each one being only a small net deficit.  

This is obviously something that cannot continue indefinitely (although Japan shows that it can continue for long stretches), but more worrying is that the typical path out of high debt levels has been robust growth and that is less and less possible.  I don't just mean because we appear to be in a low growth era, but that with debt levels this high more growth, which ought to lead to higher interest rates, will mean more debt payments.  Debt levels of over 100% of GDP make it very difficult to grow out of debt when starting with an annual deficit, and when you are starting with a budget deficit during growth years?  Yikes.

One might argue that a government can borrow long, locking in interest rates, and then absorb growth because it wouldn't increase its deficit.  This is true on one side of the ledger only, as it would only be transferring losses to the holders of that debt.  To make it work you need to have those losses not end up as a drag, preventing the very growth that you need to get the debt/GDP ratio back under control.

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I don't have a good segue here, so I will just plow on ahead.  There is an idea in economics called monetary offset, basically it is that the impact of fiscal decisions (ie spending decisions made in Washington DC) can't be determined without looking at what the Federal Reserve does in response.  A fiscal 'stimulus' program that expands the deficit would only be expansionary if the Fed doesn't tighten in response.  The failure of this mode of thinking is the assumption that there is a bright line between Federal spending actions and Federal Reserve actions, there doesn't truly appear to be.  One example:  If the composition of Federal spending has an impact on the economy, that spending $100 billion on defense is different from $100 billion in tax cuts which is different from $100 billion in Medicare expansion  which is different from $100 billion in interest payments, then Federal Reserve policy that effects the interest payments of a government is functionally fiscal policy.  A shift in interest costs would shift money either away from or toward other programs which would have a different 'multiplier'.  Most Keynesian models assume that there are at least some differences, with different multipliers for tax cuts vs spending increases during a recession, and most argue that 'productive' uses of money will have higher multipliers than non productive ones (Keynes himself made that argument as well).  On the flip side of this the Federal Reserve has a dual mandate to manage inflation and unemployment, and therefore any Federal spending that impacts either of these two will in fact be influencing monetary policy.

Monetary offset relies on the idea that the Fed moves last, and that after noticing the fiscal actions they will 'correct' the economic course.  It also implicitly relies on the Phillips Curve being real, or that 'stimulus' attempts can't cause UE (which are similar ideas).  If those don't hold then the Fed doesn't have the power to offset in all situations, it only has the power to choose a path and take a bad outcome either way.

I can't help but noting here that the largest recession in my lifetime came in concordance with the Federal Government and the Federal Reserve acting in combination early on (and even prior to) what was at the time a relatively mild recession.  Lost to the collective memory hole is the fact that the Federal Government passed a 100 billion dollar+ stimulus package in early 2008, before the recession was even officially a recession.  The Federal Reserve was even faster on the stimulus train having started interest rate cuts in July of 2007, going from a FFR of 5.25% then to 2% in August 2008.  

Cause of Unemployment

What were the causes of high UE during the Great Recession?  Well, it isn't getting fired.

The red line here is layoffs times 4 to rescale and make it clear that total unemployment increases first and then layoffs follow.  Here it is again with the UE rate instead of total unemployed.

Layoffs are a normal part of a healthy economy, some people are bad fits for their jobs, some jobs are bad fits for the economy or company and some companies are badly run, shifting people into more productive roles is crucial for economic growth.  Layoffs during the great recession lagged, they took longer to move out of their prior range than most other indicators.  You might think that such a relationship was obvious (employers aren't prescient and generally don't like to fire people in general) but most theories off the GR require the opposite, and so the opposite is believed.  For example 

The economy surely saw what was, fundamentally, just a reshuffling of financial players and asset ownership as a sure sign (a very bright sunspot, if you will) that bad times were here again. The reaction was shift. Employers laid off their workers in droves to lower their payrolls before their customers stopped arriving. This was the worst of the many types of multiple equilibria associated with the GR.  

New home sales had been falling for 3 years before layoffs spiked and auto sales had been falling for a year+.  Other sectors differed, restaurants saw an end to a long growth in terms of total receipts in late 2007/early 2008.  They did see a decline after September 2008, but the break from trend occurred well before that.

All retail sales minus food service saw a break from trend prior to 2008, and saw early declines before the masses of layoffs in late 2008.

"Real" Interest Rates

We are diving right into this one, no words to start, just a graph! 

Red line = Federal Funds rate, blue line = Federal funds rate minus 5 year expected inflation.

From July 2003 to June 2004 the Effective Funds rate is essentially flat at 1%, during this time inflation expectations increase by about 1 percentage point.  This represents roughly a 67% increase in the expected inflation rate, from around 1.5% to 2.5%.

What is the Fed to do?  Well, start raising rates of course.  The Fed raises rates over 4 percentage points from June 2004 to July 2006 while 5 year inflation expectations move up another 15-20% to their peak at just under 3% in early 2005.  Meanwhile at the 10 year break even rate

So 10 year inflation expectations peaks right before the Fed starts raising the funds rate, and then is in the 2.2 to 2.8 range right up until August 2008 (not shown here).  Another look

The spreads here are small, but functionally doubled.  Early in the graph 10 year inflation expectations are basically 0.35% per year more than 5 year at the widest points, given that 10 year inflation includes the next 5 years as well this implies that years 6-10 should have around 0.70% higher inflation than years 1-5.  That isn't a huge deal but it is notable when rates are in the 1.5-2% range.

What is a huge deal is that the Federal Reserve raise interest rates by 4 percentage points and inflation expectations are virtually identical after the last increase to what they were at the first increase and were slightly higher for good portions of the rate increases.

If you are of the opinion that the Federal Reserve can control inflation (expectations) with the funds rate then you are looking at a 400% increase over 2 years to stop inflation expectations from rising.  And don't give me "long and variable lags", these rates include the 10 year break even rate which stops rising BEFORE the 5 year rate does.

There is a sentiment to be found that the Fed was to tight during this period, that they either raised rates to far or held them up there for to long.  This is awkward to argue as the lower of the 5 and 10 year break even rates stays above 2.15% and they were both right around 2.35% when the Fed starts easing in 2007.  Then the Fed lowers rates by 3+ percentage points from July 2007 to May 2008 and inflation expectations stay in the range the Fed wants them to.

All of this is just a set up for

This is about as close to a smoking gun as you can have against monetarism or Keynesian economics, both of which rely on using real interest rates as a mechanism for driving down the savings rate and driving up the consumption rate to combat a recession.  First I will zoom out as far as the Fed data goes to show how poorly correlated real interest rates are with the savings rate

Now a zoomed in section from the financial crisis

The savings rate fell and held steady while real interest rates climbed.  There are multiple measures here of what a "real" interest rate should be, the 10 year bond rate minus 10 year expected inflation, the same for 5 and 5, 2 year bond minus 5 year inflation, 2 year treasury minus the current inflation rate, the federal funds rate minus 5 year inflation and they all show the same pattern.  Real interest rates climbed and the savings rate ignored them, then rates fell and the savings rate ignore them and then the early stages of the financial crisis started and the savings rate moved higher and quickly.  I'm not going to discuss the spikes here, just the trend, the savings rate went from around 4% in the early stages of the recession to above 5% in about 6 months and up to the 6-7% range with peaks above 7.5%. 

If you read my previous posts on the yield curve you would note that the stock markets started rising more rapidly right around the same time that real interest rates started rising during the above period, and not long before housing starts fell off a cliff.

I am going to return to my explanation of a bifurcated market, that there exists two (or several) different sets of participants with little cross venturing.  Low, and especially negative, real interest rates should benefit borrowers at a cost to lenders.  Higher rates should benefit lenders at a cost to borrowers, and lower rates vice versa but how many would be borrowers can benefit by switching to being lenders?  If you have a cash reserve and are thinking of borrowing because real rates are low then your cash reserves are going to suffer poor growth roughly equal to the gains you get by borrowing the money for a project rather than using your own.  Moving towards equilibrium is difficult in this way, which is why the channel of rising real rates encouraging savings and decreasing real rates reducing them is central to modern macro theories and why the above graphs are so devastating to them.

Yield Curve Part 2

In Part 1 I looked at the end of the Yield Curve (YC) inversion, when it is reverting back to the normal state of short term rates being lower than long term rates.  Here we are going to look at the early stages of flattening and then inversion.

To start with I don't think that there is much that is special about the curve inversion SPECIFICALLY.  Very flat curves are just as interesting (ie tricky to explain) as the actual inversion, and there is no correlation between the depth or duration of the inversion and the eventual recession.  The inversion in 2000 was much deeper than the on in 2005 and the 2001 recession was much milder than the 2007.  There aren't a lot of consistent explanations for why a flat curve with a 0.1% difference between the long and short rates is a completely different animal from a curve with a -0.1% difference (ie inversion). 



To begin with the blue line is stock market capitalization to GDP, which is not a commonly used metric.  I'm starting with it to head off one particular complaint and that is that inversions happen when the Fed raises rates and the Fed raises rates when the economy is doing well and markets should go up when the economy is doing well.  Market cap to GDP shows (to some extent) when increases in market value exceed increases in GDP.  Lets add in the Federal Funds rate

This graph is very awkward for traditional cause and effect explanations of how the Fed should work.  First the Fed raising interest rates is supposed to slow down the economy, secondly the Fed increasing interest rates on the short end should push long end rates up (this appears to be correct, only not close to a 1:1 relationship) and third increasing short rates should push down inflation.  The latter two combined should producer higher real returns for bonds (higher returns that can be locked in with lower near term inflation) which should make bonds relatively more attractive than stocks, and the first note should slow earnings for stocks. 

Basically the Fed increasing rates ought to lead to lower stock market levels not higher, but what we see is the opposite, increases in the funds rate see higher stock market valuations in both raw levels and relative to GDP terms. 

Housing starts generally are funded with short term loans when started with borrowed money.  For the last two recessions it looks like housing starts peaks and then falls (to varying degrees) when the YC inverts but it is hard to use cost of borrowing or bank spreads to explain this when the starts were increasing with a very flat curve in the late 90s and increasing with a sharp funds rate increase during the 2000s.  In the 2000s housing starts continue to increase for 18 months before declining dramatically.

You could argue that this supports the conclusion that an inverted yield curve really is a different animal than just a flat one, but I don't think this holds as a significant factor.  First new home starts in the 90s is more of a high plateau than a peak and the decline isn't steep and secondly total construction employment only dips (when adjusted for housing completions which is the better metric for discussing construction employment) modestly after growing at a good rate up to that point.

This makes it appear as if there is no notable net reduction in borrowing related to construction, and neither does it appear that banks earnings were down during this period.  BoA's earning in 2007 were higher than 2004 or any year prior to that and Wells Fargo's 2007 earnings were higher than 2005 or any year prior.  Its all so counter intuitive or simply non intuitive that you can almost forgive monetarists who believe that you need higher interest rates to create inflation. 

The Yield Curve part 1

See if you can spot the flaw.

1.  Printing money lowers bond yields  More money chasing the same number of bonds means borrowers pay lower interest rates.

2.  Printing money raises bond yields.  More money pushes up prices of all goods, ie inflation, inflation reduces the real value of bonds pushing up rates.

How about

1.  Higher real rates of return increase savings.  Better yields mean the opportunity cost ratio of saving vs spending shifts towards saving.

2.  Higher real rates of return decrease savings.  Better yields means less money needs to be invested to hit retirement goals, leaving more for consumption.

Let's try empirically on the first count.

No obvious correlation between shifting the Fed Funds rate and inflation expectations. 

And no obvious correlation between 30 year mortgage rates.  Rather than post 10 more graphs let me just say that I see no obvious connection between inflation expectations or current inflation rates and bond rates, or changes in the monetary base or currency in circulation. 

At one point the term inflation meant "an increase in the money supply" and now it generally means "and increase in prices due to an increase in the money supply".  The only thing that this clarifies is that you can't get very far using definitions. 

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Going back to the yield curve, a couple of posts ago I criticized the claim that an inverted yield curve was a causal agent in creating recessions because it reduced the incentive to lend which caused a drop in lending which causes a drop in economic activity.  This doesn't make sense for a few reasons, first there isn't any evidence in 2006 of a drop in lending when the curve inverts, nor as it is narrowing.  Secondly a drop in lending should push the long term rates up preventing or at least pushing a reversion of the curve (obviously this won't happen if lending does dry up, but its a logical hole in the argument) and finally because recessions have tended to start after the curve has started reverting. 

The best correlation in terms of both timing and logical causal power for the 2007 recession is the delinquency rates for commercial and residential property. 

To preempt some arguments.

1.  "Of course delinquencies rose, people lost their jobs and couldn't make payments". 

Delinquency rates start to rise before the UR rate, and before GDP starts to fall. 

2.  "The Fed pushed up short term rates and that caused adjustable rate borrowers to not be able to afford the payments". 

The Fed raised rates from mid 2004 through mid 2006 and held them there until mid 2007 when the starting cutting.  Delinquencies start rising in 2007 so 3 years of higher rates didn't cause an increase, and the most common adjustable rate mortgages (ARMs) are 5 and 7 year lock ins, so those people wouldn't have been hit unless they took out their mortgages between 2000 and 2002.  Anyone who did so would have been a favorite to sell their house at a large profit in 2007 rather than default as prices would have risen.  Additionally long term rates only moved up about a point to a point and a half, meaning a refinance at that time or paying the higher rate shouldn't have been wildly onerous. 

Only really short term borrowing for houses, 1 or 2 year ARMs and interest only loans, should have been at risk for sudden defaults.  In other words bad lending standards.  Commercial properties are more complicated to investigate but the conclusions are roughly the same, places that couldn't make payments weren't failing to do so because of the Federal Funds rate increases.

You also have a decent correlation on the back end with the peak of commercial properties right at the end of the recession and the peak of housing coming 9 months later, and the decline in the UE rate going along with the declines in delinquency rates. 

Lets put the YC in with delinquency rates

I left the 2001 recession in to show that the rise in delinquency rates isn't a theme common to all recessions. 

We see again that delinquencies lead, but the time the Fed pushes the YC above zero in mid 2007 the delinquency rate has already hit 2.5%, a high for this chart.  This makes sense, the Fed is reactionary and isn't going to start lowering rates on a whim, it is going to wait until it sees something in the data that needs responding to. 

This is a longish and roundabout way to get to the conclusion that the YC reversion is not causal of the recession and that the Funds rate level changes are of limited importance for most recessions by this point. 

Rising Interest Rates part 2

The first part was getting fairly long, so here is part two on rising interest rates and government debt.

The Federal Reserve is currently planning on two related courses of action in the near future, first to continue unwinding portions of its balance sheet and secondly to steadily increase interest rates and tt is difficult to see how they could accomplish the former without the latter occurring. Unwinding the balance sheet should have a dual effect on pushing up rates, first it increases the available supply of securities as they are functionally off market, and secondly should lead to lower remittances to the treasury, increasing the deficit and increasing the supply of Treasuries.

Here I am going to split the federal funds rate into two eras, 1950s through the early 1980s and the 1980s through present day












Here we have rising interest rates where almost every peak or trough is higher than the previous peak or trough up until the early 80s when we get declining interest rates where almost every peak or trough is lower than the previous peak or trough. The switch from rising to falling interest rates concurred with a dramatic shift in Fed policy. Functionally the full employment mandate was ignored for a period in the name of price stability and the funds rate was increased dramatically. As the Federal Reserve is giving no indications of a major departure from current policy I conclude that the current rising interest rate trend will be similar to the trend from the last 35+ years. Thus I expect the current rise in interest rates (as measured by the federal funds rate) to peak below the 5.25% that saw for parts of 2006 and 2007. My best guess is that it will peak under 4%, but my investment decisions will not hinge on this guess, merely be optimized somewhat in favor of it.


While Treasury rates should follow the direction of the federal funds rate there is a good chance that shortish term Treasuries will rise somewhat faster, in fact to an extent they already have.







Here we see that 1 and 2 year Treasury rates have increased by about 25% more than the funds rates since 2013 . We can also see that this happened around 1993 and 1999. That the Fed intends to wind down their balance sheet in the near term increases the chance that short term Treasury rates will rise faster than the funds rate.

Here I want to revist something I have mentioned a few times, but in more detail, that the rises in short term interest rates aren’t pushing up long term interest rates.




The Blue line is the spread between the 30 year mortgage and the federal funds rate, and the red line is the 30 year mortgage rate. Remember that the low points for the blue lines are when the spread is very small, and you can see that the spread decreases dramatically several times without much (or any) push up or down in long term rates. As long as this pattern holds (and it isn’t guaranteed as this is not the pre 1980s pattern) this should mean that short term rates peak at under 5%, and probably under 4.5%, before the Fed starts cutting into the next recession.

This is the good news for government debt, the rise in interest rates shouldn’t become a rocket and the duration won’t be for so long that all government debt feels the rise. On the other hand the federal government has been getting less good about piling on debt.







And a shift in long term rates

Inverted Yeild Curve as a casual agent

Late in a post about the yield curve David Beckworth has a quote that is almost a throwaway line

An inverted yield curve means smaller net interest margins for financial firms and thus less financial intermediation. That is, once the yield curve inverts, it goes from being a predictive tool to a causal agent.

 There is a problem with this statement, it is hard to square with the actual economic outcomes.  For example the UE rate tends to drop or remain at low levels while the yield curve is inverted (UE rate is divided by 2 in these graphs to make it easier on the eyes).

The 2000 recession

And the early 1990s recession

Nor does the market show fears of a recession

If we look at mortgage originations by quarter or by year it is not obvious that the curve inversion of late 2005/early 2006 resulted in diminished financial activity, nor that the flattening yield curve in 2005 led to diminished financial activity (there is no reason to believe that an inverted yield curve reduces earnings significantly more than a flattened yield curve).  By year, for the 2000s, the highest origination amounts were 2003, 2005, 2006, 2004, 2002, 2007, 2009, 2001, 2008, 2000.  The largest yield curve spread was in 2004 and the smallest was 2006/2007.

So, looking at the Great Recession it appears that UE decreased, markets increased and mortgage originations stayed at high levels (certainly didn't decline) and the curve was inverted for most of 2006 through June 2007 which puts some counters out of the question (such as indicators lagging by several quarters unless by several quarters meaning 6+).

So what is going on?

With all the discussion about yield curve inversions almost no one bothers to mention the obvious fact that they are stupid.  They shouldn't happen.  Why would you lend someone money at 2% interest for 10 years when you could lend that same person money at 2.1% interest for 2 years? It takes some very convoluted situations to come up with plausible reasons.  I am happy to say though that it is hard to find market based curve inversions.  The 30 year mortgage rate doesn't dip below the 15 year rate as far back as FRED data goes and neither of the 30 year mortgage or 15 year mortgage ever dips below the overnight or 3 month interbank rates.  However the 30 year treasury does, meaning it isn't simply an artifact of a longer term on the high end.

So yields invert when Fed influenced rates climb without market influenced rates climbing an equivalent amount, eventually, after multiple rate hikes, the short end pops over the long end, but again only on securities that are influenced by the Fed, and we see no overt, short term signs of broad economic trouble. 

This means that there must be, somewhere, large frictions in the financial markets.  Why?  Well investors are trying to make money, if short term rates are rising relative to long term rates then people who lend at long term rates should move into at least some lending at short terms, and some people borrowing at short terms should prefer to borrow at long terms now.  These are strong pressures and they should be somewhat proportional to the size of rate changes.

Basically people (or institutions) who are happy to lend long aren't interested in lending short, and people who borrow short aren't interested in borrowing long.  Shouldn't an increase in short rates hit the market somehow though?  People who borrow short should see higher costs and reducing their borrowing which should filter out to the market.  Well there are basically three options that you have when a strategy isn't working, switch to an alternate method, pull out entirely and double down on the current one.  Clearly switching to alternate methods of funding hasn't been happening or the curve wouldn't narrow and then invert, pulling out appears not have happened after recent inversions leaving us with doubling down.

What would this look like?  If you are going to pay more for financing without a rise in long term profitability (ie flat long term rates) then you are going to need to add risk to boost earnings.   There are a lot of reasons why such a course might sound sensible, you expect short term rates to come back down and are just trying to weather the storm, or your compensation is strongly tied to the upside and only weakly to the down side, or any other number of situations.

This expectation fits very well with what we saw in 2005 through 2007, subprime loans (representing higher risk) almost doubled as a share of the market and increased by nearly 5 times in total dollars from the late 90s.  Adjustable rate mortgages (ARMs) roughly doubled from 15% to 30% of the market as well, fitting in with our hypothesis of greater risk taking by short term borrowers (banks).  This also fits the margin run up in the late 90s as the tech bubble peaked along with an inverted yield curve.  We can also start to formulate an explanation for the inconvenient truth that the Federal Reserve has been lowering interest rates (ie easing) into each of the past 3 recessions, getting "ahead of the ball" by a quarter at least without being able to prevent it with stimulus as is supposedly possible. 

 Here we have housing prices continuing to rise with Fed "tightening" and only leveling off when the Fed stops tightening and accelerating into the decline as the Fed "loosens" and its happening again

Eventually borrowed money has to be repayed, margins have to be satisfied.  The race up where you borrow to gain exposure turns into a race down where investors at first liquidate to realize gains followed by to late investors liquidating to prevent further losses, a Minksy Moment.  However, instead of relying on explanations based on greed (aren't people always greedy?) or hubris (aren't they always filled with this?) we have a rational explanation.  The Fed cutting rates makes the previous strategies profitable again with lower risk. 

Rising Interest rates part 1

Short term interest rates, be it Libor, the Federal funds rate, 1 month Treasuries have been rising for a little while now. Absent from most discussions is the simple fact that rising short term interest rates are bad for banks, the only thing worse for banks is rising short term interest rates coupled with stagnant or falling long term rates, quickly to illustrate.

Suppose you start a bank with $1,000,000 in capital, and have a 10% reserve requirement. You raise that capital at the short term market rate of 1% interest and you loan out the $900,000 that you are allowed to at 4% interest for 30 year mortgages. You’re bank is set to make 3% interest on $900,000 or $27,000 a year which then goes to paying for your tellers, security guards, property tax, and live goats that the bank president sacrifices to Moloch every third full moon to prevent defaults. Whatever is left is your profit, and since I am pulling numbers out of my ass lets say profit rates at this level are 1%.

What happens if short term rates rise to 2% in your second year? I’ll tell you what happens, you aren’t making money anymore, you are in fact just breaking even. If interest rates rise above 2% then you are losing money and will be bankrupt as soon as those losses eat up the $9,000 in profits you booked the first year. How can you survive? Well if long term rates also go up by a percentage point to 5% you can raise more capital at 2% and lend it out at 5%. Your average profit margins will be smaller in percentage terms but they will be positive instead of zero or negative and your absolute profit will be higher if you can raise more than another million.

What if long term interest rates don’t lift off with the increase in short term rates? Well you could cut costs or try to increase earnings by betting on riskier investments. Or you could do both, you encourage your loan originators to pump out large numbers of loans and let them cut the quality of the loan recipient to do so. So you have guessed it, I am talking about the housing bubble again. Lets look at short term rates vs long term mortgages shall we?





OK, well 1 month Treasury rates went way up without 15 or 30 year mortgage rates really reacting but perhaps banks borrowing was cheaper?





Crap, you could get over 5% on a 3 month CD? What time to be alive… well unless you were a banker. I guess if you were a banker you could borrow from the Fed at low rates until things calmed down, right?





Well crap.


How could this happen though? How could long term rates stay so unfazed when short term rates increased by over 500% in less than 3 years? One partial explanation is that once rates start rising the attempt to maintain profitability means pumping more and more mortgages out the door from your staff (or just an increase in the dollar value of the average loan), basically “increasing” their productivity, and also increasing revenue from the loan origination costs. To loan more however you have to raise more capital so all the banks are competing to draw in more dollars to loan out quickly. You also have to convince people to take the loans out, which means ferocious competition on the mortgage side keeping those rates down.

This doesn’t explain everything, such as why the short term rates increased in the first place, but it fits with a lot of what happened from 2004 through 2008. The effect will be larger or smaller based on the total amount of loans made before the rates started to rise, the larger the amount the more stress on the system. How are things going now?

The spread is definitely compressing, here is the 30 year mortgage minus the 1 month Treasury rate







But don’t expect banks to make the exact same mistake twice, it is unlikely that there will be a massive surge in subprime lending this time around. Honestly they aren’t even being pressured to thanks to the Fed’s interest on reserves (IOR) program, which has had its rate pushed up to almost 2% and has basically kept pace with short term borrowing costs allowing banks to carry large amounts of reserves essentially for free recently.

The growth in debt that has been driving interest rate increases recently has been government issued.





There are three things that are particularly insane about this graph. First that the economy has been at or above full employment and debt to GDP is still increasing (albeit at a much slower rate than from 2008 through 2013), and secondly interest rates have been extremely low pushing the cost of borrowing down for the government and reducing one of its major costs. Thirdly the Federal reserve has been remitting roughly 60 billion dollars more per year post crash than it did pre crash thanks to its earnings.

The sum of these three is significant. The 2001 recession saw tax revenue drop by about 1.5% of GDP and it took until 2005 to exceed revenue from the year 2000 (partly due to tax cuts), the 2008 recession saw revenue drop by about 2.5% of GDP and did not see its 2007 peak exceeded until 2013. A simplistic projection assuming tax receipts in 2007 staying stable vs dropping implies that the crash added 1.2 trillion dollars to the debt due to lower tax receipts alone. This would be more if you compared to the average growth rate of receipts leading into this era. Meanwhile the Fed has remitted around 600 billion dollars more to the Federal government over the last 10 years more than the trend leading into the Great Recession, and interest rates on government debt have been extremely low, had they been merely low (2 percentage points higher) with the same spending+tax rates then debt would be around 2 trillion dollars higher.

The fact that Federal debt levels have risen as a percentage of GDP over the past two years with these tailwinds is concerning, but there are a few points preventing things from getting out of control immediately. First is that only about 60% of the Federal debt comes due in the next 4 years, which means that an interest rate hike of 1 percentage point right now would increase annual debt payments by less than 25 billion (assuming an even distribution of maturing debt over the next 4 years) in the first year, and of around 90 billion by the end of the 4th year.

The second major point is that during a recession the Fed typically ‘stimulates’ by slashing interest rates and increasing its balance sheet which increases remittances, meaning that the Federal government is unlikely to have to fact the trifecta of rising interest rates, lower remittances and lower tax revenues all together.

To be continued.

Picking up Pennies and the Steamroller

Short term gains don't always translate into long term gains. The obvious example is selling options, you sell a put every year for $1,000, adding a grand in earnings every year right up until the market tanks and you have to pay out a large sum. Some investigations have shown that put sellers make more money off the puts than put buyers do off the large, but sporadic, payouts. However, and to the surprise of many people, how much money you make is only half the game, when you make it also counts for long term investing. Lets take a hypothetical example using some historical data (and some guesses/approximations).

For example I pay $1,000 for a put option on the S&P 500 to you every year on January 1st and you turn around and stick that money in the market. Years one through five the option expires worthless, and then year 6 there is a market crash and I cash out my put for $5,000 and put that $5,000 in the market. The simplistic view is that you are currently ‘up’ $1,000 on me, as I paid you $6,000 and you paid me $5,000 out. A slightly better version is that you are “up” $1,000 plus gains from having that money in the market for 5 years. The correct answer though depends on what happened after I put the money in the market. I got a lump sum that was conditional on the market dropping a substantial amount, and there are certainly times where putting $5,000 in all at once out preforms putting $1,000 in 6 separate chunks.

Following our hypothetical you might have invested $1,000 in Jan 2003 when the S&P was around 900, 2004 at ~1,100, 2005 at 1,200, 2006 at 1250, 2007 at 1,400, and 2008 at 1,450 meaning your average purchase price is (ignoring dividends etc) a little over 1,200. I instead get $5,000 to invest at the end of 2008/early 2009 when the market is around 950. Come 2018 my $5,000 purchase in 2008 is worth a (with the S&P at 2,900) little over $15,000. The $6,000 averaged at 1,200 is worth a little over $14,500.

This shows how buying puts can, potentially, turn a profit even when it "costs" more to buy a series of puts than the total payout because the award was associated with the best market buying opportunity in recent memory.  What about the put seller?  Is he also "up" $15,000 having put none of his own money in play and was just riding off your $6,000 in capital?  Well no, he paid you $5,000 so he can't be up the $15,000, is he up $10,000 then?  Well, no.  He owes you $5,000 in 2009, not in 2018.  So is he up $1,000 compounded from 2009 to 2018?  No again. To get the $5,000 he (to make it simple) sells the exact shares he bought with the $6,000 you paid in yearly installments.  He bought when the S&P was at an average of 1,200 and $6,000 bought him 5 "shares" of the S&P, but he is selling when the market is around 950, and 5 shares of the S&P at 950 sells for $4750.  The other $250 has to come out of his own pocket, so his profit in this example is -$250, even though he got $6,000 for a payout of $5,000.

There are a lot of lessons you could glean from this example, such as don't keep your collateral in the same securities that your obligations are priced in.  

Returns and Crashes

Buy and Hold.  This is the strategy of the EMH, where you humbly accept that you can't beat the market, and just hitch in and ride along.  Just don't sell during the downswing and you will be fine.  Just don't sell.

Are you better than the market?  Do you know better than the average?  If you take this advice you are tacitly assuming that you know better than most people, that you are better at not selling.  Not selling, which some people struggle with during bull runs (gotta lock in my gains!), becomes much harder during a down swing.  Why do markets fall?  Because there are more buyers than sellers.  Straight line definition, if no one sold there would be no downswing!

But we get downswings, and not just normal buying and selling, massive volume downswings with 5x the volume of pre-crash movements at times. 

So why are you better than the market at not selling?  Why are you going to be better than the guy yelling "sell, sell, sell" when the panic hits?  How is this justification different from the guy analyzing Tesla's balance sheet and coming up with 'reasons' why his position is the right one?  Remember that your investment strategy, no matter how simple, requires you to be good at something, even if it is "not selling" just to match the market. 

Do people sell because markets crash, or do markets crash because people sell?  The two are inseparable, to avoid selling you need to have an idea of why people commit this investing sin.

A lot of selling is structural.  People who profit from selling puts during the bull market end up selling into the dip quite often.  Sometimes they are literally forced to sell to pay out when the option approaches expiration, and sometimes they notice that the value of their collateral is dropping while their obligations are jumping.  Selling puts and using securities as collateral doubles your leverage, more gains in good times and more losses in bad.  Some people feel forced to sell as they see bonuses dry up, fear of unemployment, and declines in other personal assets that accompany (or cause) recessions.  These relationships can be large and complex, when the markets were demanding that AIG raise capital in 2008 they went borrowing, at least some of the people that they borrowed from would have sold stock to make the loan or buy equity in AIG. 

Leverage is the number one cause of selling, and it can come from anywhere be it covering a position that turned against you or the car payments you owe on the vehicle you stretched to buy.  Did you co-sign your child's college loans?  Welcome to leverageville, population: you. 

The Paper View of the Economy

What distinguishes the Austrian view of macro economics from the Keynesian or Monetarist view is simply the level of focus.  Keynesian and Monetarist views rely on the paper representation of the economy, where the functions of the economy are aggregated and then represented by a series of numbers giving them a bird's eye view of everything.  Low resolution at the points which generate the numbers, but a good broad overview, while Austrians take some (not even a lot in particular) of that granular generator into account. The lack of communication across the schools which have many otherwise similar assumptions and conclusions about economics seems to be because of a modest shift in the underlying assumptions.  A claim under one set of assumptions would sound false and perhaps even ridiculous while being perfectly reasonable under another, its the nature of modeling (yes, what Austrians do is fundamentally modeling).

One issue with the paper view of the economy is the urge to translate it down levels which look like paper representations, but aren't.  Stock prices are a great paper view of a company, if you buy shares of Tesla and three years later those shares are worth 30% more then you can realize a 30% profit.  It doesn't matter if the shares rose because of an increase in sales, or the change of a CEO, or new product lines or a contract with the government.  It also doesn't matter (as long as you weren't leveraged) at the end of the three years if the price jumped 30% in the first year and then was flat, or fell and then rose or rose as a constant rate.  All the changes together, plus all the other changes in the economy, should be reflected in that one price as best the market can tell.  So if you want to follow the value of a company the stock price multiplied by the total shares is all you really need.  

All prices however are not inclusive.  Home prices are a good example of this, if you buy a house to hold in the hopes that property values will rise and let it sit empty for three years and then sell it for 30% more than the initial purchase price you have not made a 30% return on your money.  Why not?  Because as any homeowner knows houses come with carrying costs, you have insurance, taxes and maintenance costs.   You can see this quite clearly when developers buy property with the intention of tearing down existing structures.  They tend to tear down as soon as possible, even if they aren't intending to build immediately, as the taxes and insurance for an empty lot are generally significantly less than for lots with buildings*.

When you make an investment in housing based on expected sale price appreciation the length of time between purchase and sale is important to calculating expected returns.   Scott Sumner wanders into this distinction without noticing it in a recent post on the recent growth oinLas Vegas.

But I argued that these cities were fast growing, and this problem was relatively mild.  In my view the malinvestment is better termed “too early investment”—some houses were built a few years before they were needed.  The Austrian counterargument was that these houses would remain empty for decades, and eventually depreciate sharply (in a physical sense.)  It looks like I was closer to the truth.

Lets look at some basic estimates for carrying costs.  Property taxes plus insurance tend to combine for about 1.5-2.5% of a properties sale vale annually.  Long term interest rates during the last leg of the housing bubble were around 6%.  Estimated carrying costs for a unit would be around 7.5%** without figuring any housing depreciation or maintenance. 

Lets look at house prices

Home prices are currently about 25% off their 2006 peak after a 6 year run up.  So lets say you borrowed money and built a house you expected to sell for $230,000 in 2006, and you expected a 5% profit from it after all yous costs (including any transaction costs and the cost of financing your loan for 1 year while it was built), so your total costs would be around $219,000.  You go to sell now after riding out a huge downswing, your carrying costs have eaten up 88% of the $219,000 which is ~$193,000 in costs over the years (not compounding).  Then you go and sell at today's prices of $185,000.  Your final 'profit' on that project is negative $227,000.  

Ok, but you aren't that dumb, why leave the place empty for 12 years, rent it out and that negative $227,000 will be a reasonable number.  Well Vegas currently has a price to rent ratio of about 20:1, so a house that sells for $185,000 now would rent for about $9,300 a year, over 12 years that would be $112,000, but Vegas had a vacancy rate of around 10% over those last 12 years, pulling that down to $100,000, making your final loss on that $219,000 loan about $127,000**

So actual market returns on Las Vegas construction that was started late in the housing bubble are reasonably calculated at about -58%, and the Las Vegas housing market crash saw about a 60% decline in prices, which is pretty effing amazing projection for a market that was in 'crisis'.  

To justify Sumner's claim that the housing was "to early investment" you have to extrapolate the price trend of the last 6 years another 10-15 years to get to that investment at a break even point. So housing construction in Las Vegas was to early by AT LEAST 25 years, under the best assumptions.  

*There is more to this story as the cost of tearing down carries either interest payments or opportunity cost of that money, so you can see speculators sit on buildings for long periods of time. 

** These numbers understate the case quite a bit, the price to rent ratio is for gross rent, which assumes that utilities are included which then come out of the owners pocket, and it includes nothing for general maintenance and doesn't adjust for the fact that rents in Vegas are higher now than they were over most of the past 12 years.  These more than compensate for lower interest payments that would have come from using the rental into to pay down principle.  

EMH and the Fed, part 2

I finished the previous post with an implication about the Fed. The EMH basically assumes that all participants are profit seekers, and the Fed lives in a nebulous world when it comes to profit. They are, of course, extremely profitable, remitting $80 billion dollars to the US treasury in 2017, which is tens of billions more than the most profitable companies in the world pulled in. On the other hand they are literally allowed to print money and not making a profit would be difficult with that power. The man goal over at the Fed however is not to make a profit, it is to ensure ‘economic stability’.

It is a fairly straightforward proposition that any market inefficiencies created by the Fed are going to be proportional to the size of its interaction (that is interference from this point of view) with the markets, which is half of the reason that this topic is timely now. The Fed took previously unheard of positions in markets in an attempt to stabilize after the 2008 crash and introduced new programs like interest on reserves (IOR) which continue to influence the market now. 

The second half of the explanation is that the Fed also committed to actions during the 2008 crisis and that has set some level of path dependency for their future actions. While there were a few predictions prior to the 2008 crisis that the Fed would go to extraordinary measures in the event of a crash the particulars were thin. It wasn’t obvious how big the crash would be, how it would pass through the economy, what the Federal Government’s response would be and what the Fed’s choices would be within this context. The actual actions of the Fed have limited its possible courses for the next recession, and as i will go into further detail in future posts will set up a tension and possible showdown with the Federal Government at that time.

This is my first level reconciliation of the EMH and Austrian Business Cycle Theory, that the EMH is a strong and persistent force that generally makes beating the market difficult, but that monopolistic interventions in the market made (in this case) by the Fed can open up brief windows that will allow outsized gains to be made and that those gains are proportional to the size of the intervention. The size of the intervention has been large, and I will go into further detail about the conditions that will force the Fed’s hand in future posts.

EMH and the Fed, Part 1

The Efficient Market Hypothesis

If someone is going to offer you investing advice (for free or for a price) they are implicitly taking a stance on the Efficient Market Hypothesis (EMH), those suggesting individual actions are taking the con stance and those suggesting low fee mutual funds the pro. Either way it is interesting that so few people argue for or against it with so many financial advisors out there, this is my stance.

The EMH basically states that you can’t consistently outperform the market because any information that would lead you to a better than average decision is going to be incorporated into the price quickly (how quickly and what type of information? Well that is why there are different versions of the EMH). To make a big leap here the fewer people believe in the EMH the more likely it is to be true, and vice versa. To explain a little bit, information only changes prices when individual owners shift their behaviors in response. If Tesla announced that they had produced and sold twice as many cars as they had expected in a quarter you will see people who were thinking of selling pulling their shares off the market, shorts covering their positions and people who doubted Tesla’s long term situation convert and try to buy stock. These are the actions that shift the stock price in the wake of the news.

Imagine a world filled with passive investors, chunks of paychecks are automatically routed to funds to buy shares based on a predetermined algorithm, where no one picked up the phone or logged into their online broker when they read the news, content to sit back and collect dividend payouts from companies. What happens in this world is that stock prices rarely, if ever, move, and the market would be as easy to beat as you could hope for*. Contrast that to a world where every person is scouring source material, reading perspectives, following announcements and building models, this is a world in which gaining an edge is enormously difficult. Why would you even bother trying to beat the market in such a world? Why not just accept average returns and save all the aggravation?

Or to put it another way people who don’t believe in an efficient market are the ones creating the efficient market.

This concept doesn’t apply just to stock markets, a few months ago David Henderson had a post that touched on a related idea where he says “But now consider what happens if people expect, with higher oil prices now, that there will be more production a few years later. Why a few years? Time to drill, time to explore, time to discover. So futures prices a few years hence fall.”

If you take his thought one step further you get to the idea that high oil prices now will cause people to invest in drilling and exploration and lead to lower prices in the future. I really like this example because you can completely bake your noodle imagining causal chains, where noticing that oil production is going to be insufficient in the future causes you to buy futures contracts, which drives the future price up, which causes people to horde oil to sell at that higher price which causes a shortage today. Or buying those contracts pushes up the price, which encourages more marginal exploration and investment which leads to an increased supply and prevents the shortage.

This is the world of markets, where discovering a truth can change it into a falsehood.

Or take Warren Buffett, the richer, more successful and more well known he became the more people picked up copies of “The Intelligent Investor” and tried to apply it’s methods and logic. Naturally those investors are functionally competing with each other, driving up the values of the stocks that are considered undervalued and reducing returns. Rather than turning 1,000 people into the next Warren Buffett the popularity of value investing will prevent the next Warren Buffett from arising in that space.

This is the world of markets, where past performance doesn’t indicate future performance.

This is my view of the EMH in action, it is not that there is no move you can figure out that will beat the market but that figuring it out is the action that will close that window. How quickly the window closes depends on how efficient the market is and how many people noticed it, which is obvious. What is less obvious is that a window can remain open if there is an entity that isn’t profit oriented or capital constrained functionally keeping it open.



*Or perhaps impossible, as every buyer needs a seller.

Causes and/or indicators of recessions

From one point of view every recession looks different. There were deflationary recessions and hyperinflationary recessions which led some to posit that regular old inflation was incompatible with recessions. When their suppositions were proved incorrect we got the term stagflation and a host of new explanations mostly based on what we hadn’t yet seen. After a few more it was near universally agreed that what we definitely hadn’t seen was a broad recession cause by declining housing prices, another example of noticing a truth causing it to be no longer true. So we can have hyperinflation, deflation, stagflation, bubbles in abstract goods (the tech bubble) or solid goods (the housing bubble).

On the other hand, at least recently, recessions seem to have some similarities. The 10 year minus 2 year yield curve (YC) has inverted before each of the last 5 recessions in the US. In each of the last 3 recessions the yield curve reverted before the official beginning of the recession, and each of those events saw market prices reach their absolute peaks after the inversion of the YC.

There are four basic possibilities when two things appear to be strongly correlated, with our example it could be that the recessions was causing the yield curve inversion (unlikely since the inversion occurs first, and sometimes reverts before the recession), it could be that the inversion causes the recession, it could be that both have the same cause or it could just be a coincidence that will disappear in the future (I am disregarding this one for now at my own peril).

So let us take a look at the inverted yield curve. First off it makes no economic sense for the curve to ever invert, because the curve is about lending to the same entity. If the government defaults on its debt in the next two years this will affect both holders of 2 year treasuries and 10 year treasuries, so any risk that is built into the 2 year is built into the 10 year. The 10 year bond can have risk that the 2 year doesn’t, any risk that might rear its head between year 2 and year 10 wouldn’t impact the 2 year return, but would the 10. Likewise opportunity cost favors the 2 year bond, if another, better looking investment opportunity comes along you are more likely to be able to take advantage of it without other costs if you hold a 2 vs a 10 year note.

Functionally you see this in practice. 15 year mortgage rates are lower than 30 year mortgage rates, using FRED data we can see (going back to 1992, when their data starts) that the 15 year rate never exceeds the 30 year rate, this is what you would expect from a reasonably rational market.





This is not an artifact of looking at the longer end of the curve as the 30 year Treasury minus 10 year Treasury was also inverted before each of the last two recessions. This gives us a clue, rates that are (more) market based don’t invert even in the face of major financial issues in the economy. I would say this makes it likely that the cause of YC inversion lies in non market participants, be it the Fed or the Federal government.

Now an inversion could occur one of two ways, either the shorter term rate rises faster than the longer term rate or the longer term rate drops faster than the shorter term rate.









Here we see in each of the last 3 inversions the short rate has risen faster (this is also true for the previous two recessions but the graphs are far harder to read on those longer timescales). It is also true that each time that the YC reverted it did so with the shorter term rate falling faster than the long term rate.

There is in the data set one false positive, with a brief inversion in 1998, this did not shortly preceed a recession. This is also the only one where the inversion came with the long term rate falling faster than the short term rate.

If we take what is generally accepted, that the Federal Reserve controls (or has more influence over) the short end of the curve we have our culprit. We can feel fairly confident of this particularly because the short rate falls to cause the reversion. If the long rate bounced up to cause the reversion it might be that the Fed was simply ahead of the markets sometimes, or some other explanation, given the Fed is basically always raising rates into the inversion followed by lowering I am calling this capitulation by the Fed. 

Now we know that the Fed has a dual mandate, full employment and price stability.









This graph is a little busy, so a brief description is in order. The blue line is the employment rate that the Fed cares about the most, it is the unemployment rate (UE) minus the Natural Rate of unemployment (NRUE), full employment is when this line is at zero, and in an ideal Fed world is where it would always be. The red and green line are different inflation measures.

What I think is of note in this graph is the lack of any inflation driver that would have convinced the Fed to raise rates in any of the events leading up to the inverted yield curve. A couple of better looks with the YC and the inflation measures together.
















So two final graphs to wrap this portion up





First


The YC vs UE - NRUE

It appears that UE-NRUE leads the YC into its inversions








The Federal Funds rate vs UE-NRUE

Here is the interesting stuff. In theory the Fed stimulates the economy by lowering the Federal Funds rate. This is supposed to increase borrowing in turn increasing investment which in turn increases employment. The flip side is also supposedly true, the Fed raises rates to slow down an overheating economy and reduces employment. This graph shows that the opposite is basically occuring. There is a natural objection here, that the Fed reacts to the market and they raise rates when UE is to low already, and lower rates when it gets to high. I do not think this is a satisfactory explanation. In 1989 when the funds rate starts dropping the economy is supposedly above full employment, it doesn’t get to the “ideal” line of full employment until the start of the recession. The same thing occurs in 2000 and 2007, and one interpretation of this is that the Fed’s one measure of a healthy economy doesn’t occur until a recession hits.