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Hal Snarr: The Yield Curve Accordion Player

March 3, 2017


The yield curve (a plot of interest rates versus the maturities of securities of equal credit quality) is a handy economic and investment tool. It generally slopes upward because investors expect higher returns when their money is tied up for long periods. When the economy is growing robustly, it tends to steepen as more firms break ground on long-term investment projects. For example, firms may decide to build new factories when the economy is rosy. Since these projects take years to complete, firms issue long-term bonds to finance the construction. This increases the supply of long-term bonds along downward-sloping demand, which pushes long-term bond prices down and yields up. The black dots along the black line in the figure below gives the 2004 yield curve. It slopes upward because a robust recovery was underway.

Yield curves flatten out when investors believe a recession is looming. This results from the demand for long-term bonds rising as investor confidence wanes. As demand shifts out along upward sloping supply, long-term bond prices rise and yields fall. On the other end of the yield curve, short-term bond rates rise. This is a result of investors demanding fewer short-term securities and more long-term securities. In response, suppliers of short-term securities lower prices to attract investors. The black dots along the red line in the above figure gives the 2007 yield curve. It is flat because the Great Recession of 2008 and 2009 was just around the bend.

The red points in the above figure correspond to the federal funds rate. In 2004, the Fed had set it near 1% for about a year to stimulate the economy out of the 2001 recession. After it kept rates too low for too long, it moved it up to 5% in 2007. As it did this, the yield on the 10-year (120-month) treasury was mostly unaffected. The other treasury yields were all pushed up toward the 10-year yield. The figure implies that the Fed has less and less control over treasury yields as maturity increases.

I call the three-dimensional diagram below the Yield Curve Accordion. The red line is the federal funds rate through time. It has a zero maturity. The gray curves are the yields of various treasuries through time. As the gray darkens, the maturity gets further into the future and your eyes go deeper into the figure. For the year 2004, walking up the gray curves maps out the above 2004 yield curve. Thus, instead of a given year’s yield curve rising from left to right (as it does on the 2004 yield curve), it rises the deeper it goes into the diagram below.

The Yield Curve Accordion tells the same story that the two yield curves in the first figure did. The steps from the red curve to the lightest gray curve are slight. This results from the 1-month yield generally following the federal funds rate. In 2004, going from a lighter gray curve to the next slightly darker gray curve is a step up. In 2007, these steps are all relatively flat.

The Yield Curve Accordion implies that the Fed puts the squeeze on interest rates. After the Fed raises the federal funds rate above the 10-year yield, recessions are triggered about a year later. After a recession occurs, the Fed lowers the federal funds rate. This pulls shorter-term rates below the 10-year yield. The shorter the maturity of a treasury, the closer its yield gets to the federal funds rate.

Critics of what I call Yield Curve Accordion Theory will argue that bond rates rise before the Fed starts to hike rates. This suggests that markets dictate Fed action. However, when the TIPS spread (the difference in the yields of conventional Treasury bonds and Treasury Inflation Protected Securities) and inflation rates (from the CPI and PCE) are on steady upward trends, hawkish Fedspeak becomes increasingly more credible. Consequently, markets price in this information prior to the Fed withdrawing its monetary stimulus. This suggests the Fed plays the Yield Curve Accordion.

Yield Curve Accordion Theory is a visual representation of Austrian Business Cycle Theory (ABCT) that Ludwig von Mises and F.A. Hayek developed. ABCT says the business cycle results from central banks, like the Fed, putting the economies they preside over on unsustainable growth paths. Artificially low interest rates cause an excessive growth in bank credit. This produces malinvestment (the extra investment that would not have otherwise occurred) and overconsumption (the extra spending on consumer goods that would otherwise not have occurred). These represent an unhealthy competition for resources that are limited in the short run. The resulting mal-competition, if you will, pushes home and stock prices ever higher.

The economic boom caused by excessive bank credit is unsustainable because the only known cure to the cancer of rising inflation is the painful rate hikes of central banks. In the US, a sustained upward trend in the TIPS spread, PCE inflation, and CPI inflation tip off investors that the Fed is about to hike rates. When it does, housing and stock bubbles pop, huge positive returns on heavily leveraged assets turn negative. As prices continue their descent, increasingly more leveraged assets are underwater, loan defaults rise, and the boom becomes the bust.

If the Austrians are correct, the Fed is the Yield Curve Accordion player. It pulls its accordion apart to stimulate the economy out of recession. This steepens the yield curve. When it needs to slow the accelerating inflation it previously created, it pushes on its accordion. Doing that flattens the yield curve. At a gut level, investors now this to be true because they “don’t fight the Fed” when allocating their investment funds.

 

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Hal Snarr: More on Fiscal and Monetary Folly

February 24, 2017


“You can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time”. – Abraham Lincoln

 

Economists have long understood the effects of rational expectations on the economy and policy-making. Irving Fisher recognized that current spending depends on current and expected future income. Although John Maynard Keynes’ consumption function implies that spending depends on today’s disposable income, he acknowledged that “waves of optimism and pessimism” could affect economic activity. Milton Friedman’s permanent income hypothesis implies that current consumption depends on the present value of expected future incomes.

After Milton Friedman and Edmund Phelps pointed out that monetary stimulus does not affect unemployment over the long run, because workers can only be fooled into accepting employment at inflated wages in the short run, Robert Lucas took and ran with this idea all the way to the 1995 Nobel Prize. After adapting microeconomics’ rational expectations to macroeconomics, he concluded that monetary policy could only work over the long run—if money grows at a rate that was more than expected.

Rational expectations theory implies that you can fool most of the people in the short run, but you cannot fool most of the people over the long run. If it is ignored, mainstream macroeconomics says fiscal stimulus can boost aggregate demand. In the hypothetical situation modeled in the figure below, aggregate demand shifts from the black line labeled AD to the gray line. As aggregate demand increases (from point A to point B), high unemployment declines toward its natural rate.

The loanable funds market above shows why fiscal policy is fiscal folly. When Treasury supplies more bonds to finance fiscal stimulus, it demands more loanable funds. This shifts loanable funds demand from the black line labeled DLF to the gray line. This results in a higher interest rate—assuming the Federal Reserve does not intervene. Higher interest rates reduce private investment and increase foreign purchases of U.S. securities. U.S. exports fall as foreign investors demand more dollars. These effects combine to push aggregate demand back down to point A.

Under rational expectations theory, households anticipate that government will raise taxes in the future to retire bonds it used to finance today’s fiscal stimulus. Because this will reduce future economic activity and disposable incomes, people will save the money they receive from today’s fiscal stimulus to pay tomorrow’s higher taxes. The resulting increase in savings means consumption and investment do not rise by what government had expected when it enacted fiscal stimulus. Instead of aggregate demand shifting outward, it remains at point A, and unemployment remains high.

The increase in savings also raises loanable funds supply from the black line labeled SLF to the blue line passing through point E. Since financing fiscal stimulus pushed demand from the black line labeled DLF to the gray line that also passes through point E, the loanable funds market equilibrates at point E. At the new equilibrium, private investment remains unchanged at $10 trillion, and the $500-billion fiscal stimulus, which had raised loanable funds to $10.5 trillion, is financed at the same rate as private investment, 2.5%.

Thus, fiscal stimulus is impotent in rational expectations theory because it has no effect on private investment, exports, GDP, interest rates, and unemployment. Recent experience with tax cuts and rebates supports this conclusion. According to Gary Shilling, “consumers saved 80% of the tax rebates they received in the summer of 2008. And they initially saved 100% of 2009’s tax cuts and special payments [to each] Social Security beneficiary” (“The Chances of a Double Dip,” BusinessInsider.com, 9/20/2010)

Since 2008, the Congress, President and Federal Reserve have enacted historic fiscal and monetary stimulus. The Fed paid banks interest on reserves, kept interest rates near zero, and digitized trillions of dollars in new money. Congress and the President temporarily cut taxes, spent billions on shovel-ready projects that were not shovel-ready, and raised government debt to $20 trillion. The doubling of government debt, the trillions of idle new dollars that are waiting to become inflation, and the growth of onerous regulation are infringing on our personal and economic liberty. This lose in liberty is reflected in our country’s economic freedom ranking dropping 12 spots from fifth in 2008 to 17th today (see www.heritage.org/index/download).

The solution to the near decade-long recessionary gap is more personal and economic freedom, not more fiscal and monetary policy. In our heart of hearts, we know this to be true. We buy products and services from businesses that are relatively free of government intervention, and from enterprises that are heavily regulated, managed, or owned by the government. In the former, prices generally fall and quality tends to rise (e.g., Lasik eye surgery, cellular phones, tablets, electronics, software, and computers). In the latter, there is inflation, stagnant quality, inefficiency, or moral hazard (e.g., health care and insurance, telephones prior to the Bell System breakup, banking, public education, and U.S. Postal Service).

With all the economic stimulus that was thrown at a near decade-long recessionary gap, it is time to seriously consider ending monetary and fiscal folly.

 

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Hal Snarr: Economic Stimulus Follies

February 14, 2017


When the U.S. enters a recession, politicians, their appointees, and their media allies begin banging their economic stimulus drums. The pro-business party beats the tax-cut drum, the pro-labor party beats the raise-government-spending drum, and they and the Federal Reserve (Fed) beat the reduce-interest-rate drum. These drums get beat because macroeconomic theory says these “solutions” boost aggregate demand.

Economic stimulus is an easy sell when unemployment is rising and asset prices are collapsing. Cutting taxes, mailing out government checks, and lowering interest rates puts money in the pockets of Americans. More money in the hands of consumers, workers, firms, and government agencies means they buy more goods and services. More goods and services sold means more is produced. More production means more jobs. Since this means more people have more money to spend, the spending cycle repeats itself, over and over.

When the above narrative is explained using elegant Keynesian equations, it is even more convincing. However, analysis from the only graph that John Maynard Keynes put in The General Theory of Employment Interest and Money (1936), the loanable funds market, reveals the folly of economic stimulus.

The loanable funds market is made up of savers and borrowers. Savers supply loanable funds whenever a bond is purchased, money is deposited into savings accounts or banks lend money to consumers and firms. Borrowers like the firm that sells its corporate bonds to investors, the consumer that gets a loan to buy a home or car, the bank that accepts a savings deposit, and the government that auctions securities to finance fiscal stimulus (tax cuts and increased government spending) are demanders of loanable funds. The size of this market, as measured by our national debt, is around $60 trillion.

The price of loanable funds is the interest rate. At 0% interest, borrowers demand a lot of loanable funds, but savers will not supply them since zero interest is being paid. This shortage of loanable funds declines as the interest rate rises. Savers are induced into supplying increasingly more money as the interest rate rises. Borrowers demand fewer and fewer funds as credit gets increasingly expensive. The shortage disappears at the equilibrium, which occurs when funds demanded equals funds supplied.

The realistic hypothetical of the U.S. loanable funds market depicted in the figure below assumes government is required to balance its annual fiscal budget. With demand and supply crossing at point O, the interest rate is 1% and the quantity of loanable funds is $50 trillion. If government is permitted to spend more than it collects in taxes, it must sell bonds to finance it. Holding the interest rate constant at 1%, the $20 trillion in accumulated government debt shifts loanable funds demand from the black line labeled D to the gray line labeled Dʹ. With supply held constant at the black line labeled S, loanable funds demanded is $70 trillion at point M and loanable funds supplied is $50 trillion at point O. Economists call the difference in these values a shortage. It causes demanders to bid the interest rate up to 1.6% at point F.

At the new equilibrium, the interest rate equals 1.6%, which is roughly equal to the 10-year Treasury bond yield, and supply and demand equilibrate at $60 trillion. Subtracting the $20 trillion in government debt from this amount gives private investment of $40 trillion. As government borrowing raises the interest rate from 1% at point O to 1.6% at point C, private sector borrowing declines from $50 trillion at point O to $40 trillion at point C. This process suggests that government borrowing crowds out $10 trillion in profitable domestic projects.

Fiscal stimulus has other consequences, both foreign and domestic. Higher rates in the U.S. induce foreign investors to buy more U.S. securities and shelve profitable projects that they would have otherwise undertaken in their home countries. The dollar appreciates when this happens because foreigners need dollars to buy U.S. securities. This pushes up the prices of U.S. goods, which reduces American exports. Although fiscal stimulus is supposed to push the economy out of recession, it’s intended effects (boosted aggregated demand from greater business, consumer and government spending) are offset by its unintended consequences (higher interest rates, crowding out, and reduced exports). Since wars were and are financed by government bonds, government debt also results in wars that may not have occurred otherwise.

Monetary stimulus has unintended consequences as well, which are explained using the realistic hypothetical above. Suppose the increase in bond demand from the black line labeled D to the gray line labeled Dʹ was instead caused by economic growth. Now, imagine that firms are considering a myriad of profitable projects that cost a total of $20 trillion dollars. If these projects are placed in a risk queue from least risky (at point O) to most risky (at point M), all projects are undertaken—provided the interest rate remains at 1%. Borrowers, however, bid the interest rate up to 1.6% (point F) because there is a $20 trillion shortage of loanable funds at 1%. At the higher interest rate, demand and supply equilibrate at $60 trillion, the riskiest projects are abandoned, and only the least risky projects are financed.

Suppose the Fed had set the interest rate at 1%. To enforce this price ceiling, it must print money to paper over the $20 trillion shortage at 1%. At this artificially low interest rate, all projects in the $20-trillion risk queue are undertaken. Austrian economists refer to the risky projects, which would have been canceled had the Fed not intervened, as malinvestment. Similarly, the consumption that would have otherwise not occurred at 1.6% occurs at 1%. Austrian economists refer to this as over-consumption. It and malinvestment represent an unhealthy competition for resources that are fixed in the short-run. This mal-competition, if you will, inflates asset prices and pushes the economy beyond its short-run capacity.
Everyone enjoys a Fed-induced boom… until it busts. Investors do well following the mantra: “Don’t fight the Fed.” Consumers convert home equity into cash to remodel their homes, buy new cars, or take fabulous Caribbean cruises. However, as inflation expectations begin to creep up, the Fed withdraws monetary stimulus. This causes prices to crest and fall, returns on leveraged assets to turn negative, loan defaults to rise, and the boom to bust.

Economic stimulus follies will continue to damage our economy unless we stop viewing the Fed, the President, and their media allies as some kind of all-knowing oracle. Even if we assume they genuinely want to do good, their actions represent a cage. If we are not released from it, we will become institutionalized like Brooks, the parolee who committed suicide after a 49-year incarceration in Shawshank Prison (Stephen King’s fictional New England prison). Shawshank was unable to take Andy, but it almost got Red.

Do we want to be Brooks, or that neighbor’s dog that has been locked in a backyard kennel for 10 years? If the political oligarchy set us free from their do-goodery, we may sit in our open cages for a few days wondering where the food and water is. This short-run pain will pass when we tire of waiting to be watered and fed. At that moment, when we stick our heads out of our cages of moral hazard, which government has financed with decades of debt, we will take a step toward freedom. The air will be fresher. The grass will be greener. We will get excited again because we will realize that we are finally free to pursue our passions. It will be the start of a long uncertain journey.

 

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Hal Snarr: Mainstream Monetary Malpractice

February 8, 2017


In remarks last fall to the Hayek Group of Reno, Nevada, San Francisco Federal Reserve Bank President John Williams said, “that an economy that runs too hot for too long can generate imbalances, potentially leading to excessive inflation, asset market bubbles, and ultimately… recession… [The economy is] at full employment, and inflation is well within sight of and on track to reach our target… it makes sense to get back to a pace of gradual rate increases.”

The above remarks reflect the mainstream view that low and high unemployment are curable illnesses. When unemployment is high (or above the natural unemployment rate), mainstream economists prescribe low interest rates and excessive money growth. Just the opposite (high interest rates and slow money growth) are prescribed when unemployment is low (or below the natural unemployment rate). These “cures” to low and high unemployment are called expansionary and contractionary monetary policy, respectively.

In an economy not distorted by government interventions, unemployed workers lower their reservations wages to land positions to feed their families and pay the rent. This results in wages being bid down. This is not a winning political scenario. Whether the pro-labor party is in power or not, it and its media allies have “persuaded” the pro-business party into supporting equity interventions like food assistance for the poor, government health insurance, unemployment insurance, housing subsidies, the minimum wage, and price controls on food and energy. Even though these interventions are intended to lesson inequalities that worsen during recession, they distort labor markets and have unintended consequences.

In the absence of the above interventions, wages would fall more quickly during recession than they do now. This would lower production costs, which would raise product supply relative to demand. When this happens, prices fall and production levels rise. As firms increase output, GDP rises up toward its full-employment level. As more laborers are hired, unemployment drifts back down to its natural rate. This process is known as recessionary self-correction. Because the interventions mentioned above inhibit wages from falling during recession, recessionary self-correction stalls out. The result is persistently high unemployment. To cure it, the Fed and its media allies prescribe monetary stimulus to fix the problem that well-intentioned equity interventions created.

When unemployment is low, GDP exceeds its full-employment level, and firms find it difficult to keep up with rising product demand. Firms add second and third shifts to support this. Tight labor markets pressure a firm to pay its workers overtime wages, or seduce workers away from its competitors with better benefits and higher pay. This can push costs up, which would reduce the supply of products. As prices rise and outputs fall, GDP declines to its potential level and the price level rises. This process is called inflationary self-correction. To head it off, the Fed and its media allies prescribe contractionary monetary policy.

Since the fiscal stimulus (tax cuts and higher government spending) that Congress passes during recessions is politically popular, and contractionary fiscal policy (temporary hikes in taxes and cuts in government spending) is never enacted when unemployment gets too low, the Federal Reserve (Fed) is expected to head off inflationary self-correction with contractionary monetary.

The chart below shows just how much the Fed fears inflationary self-correction. After unemployment dipped to 5.7% in February 1988, which was 42% lower than average unemployment of the first six years of the 1980s, between then and March 1989 it hiked the federal funds rate 50%. After unemployment dropped to 4.3% in January 1999, by June 2000 it had increased the federal funds rate 41%. When unemployment dipped to 5.6% in May 2004, it raised the rate 430% from 1% to 5.3% in August 2006.

The Fed typically goes too far when it implements contractionary monetary policy. This is due impart to macroeconomic data being dated and imperfect. Its overreactions are evident when the federal funds rate in Figure 1 (the black line) is analyzed with Figure 2, which shows GDP (the red line), full-employment output (the black line), and the length of U.S. recessions (the widths of the grey bars) over time. When the Fed hiked the federal funds rate by 50% between February 1988 and March 1989, and by 41% between January 1999 and June 2000, mild recessions followed about a year later. However, when it hiked the rate by 430% from May 2004 to August 2006, the deepest recession since the Great Depression ensued a few months later.

After contractionary monetary policy triggers recession, the Fed immediately follows that action with expansionary monetary policy. When it does this, it tends to hold interest rates too low for too long. This is apparent in Figure 1. Since 1985, the length of the valleys in the federal funds rate are generally longer than its plateaus. The stimulus that Congress rolls out during recessions and prolonged expansionary monetary policy overstimulate the economy. When the TIPS spread starts rising, investors get increasingly certain that the Fed is getting ready to head off inflationary self-correction with contractionary monetary policy. Given the definition of insanity, the constant back and forth in monetary policy makes the Fed look insane.

The latest period of prolonged low interest rates is unprecedented. Since 2008, the Fed has set the federal funds rate near zero. This has coincided with the Great Recession becoming a near decade-long recessionary gap (the situation where GDP is less than full-employment output). Not only does it appear that the Fed’s historic monetary stimulus has kept the economy in a stubborn recessionary gap, it has slowed full-employment growth. Prior to the Great Recession, GDP cycled around full-employment. Figure 2 shows full-employment output being pulled downward toward sluggishly growing GDP. This suggests that historic monetary stimulus has extinguished entrepreneurism that would have occurred otherwise.

To unemployed workers, bankrupt business owners, underwater homeowners who bought homes that were beyond their means, lenders who made too many bad mortgages, and brokers who sold housing shorts, the Fed’s historic monetary stimulus was a sellable cure during the Great Recession. It, however, has debilitating side effects. In addition to the Fed’s back and forth monetary policy causing the business cycle (or at best magnifying it), the printed money from its historic monetary stimulus purchased morale hazard from most Americans. Those who received government bailouts learned that one does not need to learn from failures and bad decisions.

Given that prices fall and quality rises in markets that are relatively free of government management, ownership, or subsidization, the Fed and its partners in crime in Congress should outsource their price fixing to the millions of consumers and entrepreneurs who populate our markets.

 

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