Stakes higher, rates lower and the yield curve flatter

Outlook:

We get the minutes of the October Fed meeting today, with everyone holding his breath to see if we get a clearer perspective on the attitude toward inflation. Today we just saw a shift in perspective from the BoE minutes that mentioned “erosion in spare capacity,” a sur-prise, reminding us that minutes do sometimes contain surprises.

Bloomberg writes the Fed should be taking note that Greenspan’s conundrum is back. Greenspan was confounded when the longer end of the yield curve failed to rise in proportion to Fed funds rate hikes from 2004-06, calling it a conundrum and blaming the “global savings glut,” Bernanke’s contribution. At the time we joked that only in economics can a good thing (savings) become a bad thing (unresponsive yield curve). As Bloomberg puts it, past is prologue. “The yield on the 10-year U.S. Treasury note has fallen 0.71 percentage point in 2014 even as the Fed wound down its bond-buying program and mapped out a strategy to raise the benchmark federal funds rate from near zero, where it has been since 2008.

“… The stakes are higher this time because rates are lower and the yield curve is flatter. Raising short-term rates in the face of stable or falling long-term rates could lead to a situation where the Fed ‘quickly inverts the yield curve and turns credit creation on its head,’” says an economics professor and former Treas Dept economist. You remember the inverted yield curve, don’t you? That’s when long rates lower than short-term rates imply recession. While it’s true that an inverted yield curve precedes every reces-sion, many years ago Samuelson jibed that an inverted yield curve has predicted 38 of the last three re-cessions.

But it remains true that banks won’t lend when they can’t borrow short and lend long. It’s unclear how the Fed unloading some of its nearly $5 trillion portfolio would help. An increase in market supply low-ers price and therefore should raise yield, but when everyone knows the effect is coming, doesn’t that dilute it? Besides, the dollar was falling in the Greenspan conundrum period and now it’s stronger. For- eign investors are replacing the Fed as the chief demander of governments, especially given fall-ing inflation expectations. It’s not that foreign investors have confidence in the US being able to control inflation (as they do with the ECB), it’s that the Big Picture (global slowdown, etc.) reduces the need for a premium.

This is a pretty good argument. During the conundrum days, Greenspan worried out loud that at some point the world would have as many dollars as it could stand to own. To the degree investment managers allocate according to share of GDP and other measures, this is still true, but must be modified by the new risk metrics that have emerged over the past ten years, especially our better understanding of conta-gion, although nobody would say we have that one completely figured out. Still, Greenspan was right—there is a limit to how many dollars the world will hold and that number falls as the dollar falls if the premium doesn’t rise proportionately.

Note that yesterday’s TICS report showed foreign purchases of long-term securities at $164 billion—while they sold a better amount, $210 billion, of short-term paper. This is an outflow, although it doesn’t necessarily mean dollars sold—investors could have diverted the short-term money into some other dol-lar-denominated asset, like equities or real estate. Still, the Aug total flow was revised down from $74.5 billion to $44.8 billion. The problem with TICS data is that it feels old—the data is for September, which currency folks can barely remember. And as for demand for dollars, US investors were busy sell-ing dollars and buying foreign currencies to acquire foreign stocks ($30 billion) and bonds ($40 billion). This is the quest for diversification and yield, and it’s not stable. We were doing it in 2008, too, and it reversed on a dime when the crisis hit.

Ah, the unintended consequences of quantitative easing. Japan never emerged from deflationary reces-sion so we don’t have a model, but the implication is clear—the Fed probably wants to engineer a stable or rising premium in case the dollar falls. Therefore, it should start selling its trove of Treasuries, even if it hangs on to the mortgage-backed securities. Just thinking about that relationship makes your head spin. But one analyst made a critical point to Market News—central bank manipulation cannot change growth.

We are starting to fear that unless the Fed gets more transparent and PDQ, the dollar could be in for a fall. It’s completely understandable why the Fed doesn’t want to tell us its plans, but it would be nice to know that it actually does have a plan, and not only Plan A, but also Plans B and C. Eventually the rela-tive growth rates and diverging central bank policies should favor the dollar, but hey, the best-laid plans of mice and men. We’d start retreating.