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.