Friday, June 29, 2018

"Who’s Afraid of a Flattening Yield Curve?"

Well for one I am but then—puts on risk manager hat—I'm afraid of everything that might interfere with the Climateer march toward world domination. [insert waddling penguin gif]

From Uneasy Money:
Last week the Fed again raised its benchmark Federal Funds rate target, now at 2%, up from the 0.25% rate that had been maintained steadily from late 2008 until late 2015, when the Fed, after a few false starts, finally worked up the courage — or caved to the pressure of the banks and the financial community — to start raising rates. The Fed also signaled its intention last week to continue raising rates – presumably at 0.25% increments – at least twice more this calendar year.

Some commentators have worried that rising short-term interest rates are outpacing increases at the longer end, so that the normally positively-sloped yield curve is flattening. They point out that historically flat or inverted yield curves have often presaged an economic downturn or recession within a year.

What accounts for the normally positive slope of the yield curve? It’s usually attributed to the increased risk associated with a lengthening of the duration of a financial instrument, even if default risk is zero. The longer the duration of a financial instrument, the more sensitive the (resale) value of the instrument to changes in the rate of interest. Because risk falls as the duration of the of the instrument is shortened, risk-averse asset-holders are willing to accept a lower return on short-dated claims than on riskier long-dated claims.

If the Fed continues on its current course, it’s likely that the yield curve will flatten or become inverted – sloping downward instead of upward – a phenomenon that has frequently presaged recessions within about a year. So the question I want to think through in this post is whether there is anything inherently recessionary about a flat or inverted yield curve, or is the correlation between recessions and inverted yield curves merely coincidental?

The beginning of wisdom in this discussion is the advice of Scott Sumner: never reason from a price change. A change in the slope of the yield curve reflects a change in price relationships. Any given change in price relationships can reflect a variety of possible causes, and the ultimate effects, e.g., an inverted yield curve, of those various underlying causes, need not be the same. So, we can’t take it for granted that all yield-curve inversions are created equal; just because yield-curve inversions have sometimes, or usually, or always, preceded recessions doesn’t mean that recessions must necessarily follow once the yield curve becomes inverted.

Let’s try to sort out some of the possible causes of an inverted yield curve, and see whether those causes are likely to result in a recession if the yield curve remains flat or inverted for a substantial period of time. But it’s also important to realize that the shape of the yield curve reflects a myriad of possible causes in a complex economic system. The yield curve summarizes expectations about the future that are deeply intertwined in the intertemporal structure of an economic system. Interest rates aren’t simply prices determined in specific markets for debt instruments of various durations; interest rates reflect the opportunities to exchange current goods for future goods or to transform current output into future output. Interest rates are actually distillations of relationships between current prices and expected future prices that govern the prices and implied yields at which debt instruments are bought and sold. If the interest rates on debt instruments are out of line with the intricate web of intertemporal price relationships that exist in any complex economy, those discrepancies imply profitable opportunities for exchange and production that tend to eliminate those discrepancies. Interest rates are not set in a vacuum, they are a reflection of innumerable asset valuations and investment opportunities. So there are potentially innumerable possible causes that could lead to the flattening or inversion of the yield curve.

For purposes of this discussion, however, I will focus on just two factors that, in an ultra-simplified partial-equilibrium setting, seem most likely to cause a normally upward-sloping yield curve to become relatively flat or even inverted. These two factors affecting the slope of the yield curve are the demand for liquidity and the supply of liquidity.

An increase in the demand for liquidity manifests itself in reduced current spending to conserve liquidity and by an increase in the demands of the public on the banking system for credit. But even as reduced spending improves the liquidity position of those trying to conserve liquidity, it correspondingly worsens the liquidity position of those whose revenues are reduced, the reduced spending of some necessarily reducing the revenues of others. So, ultimately, an increase in the demand for liquidity can be met only by (a) the banking system, which is uniquely positioned to create liquidity by accepting the illiquid IOUs of the private sector in exchange for the highly liquid IOUs (cash or deposits) that the banking system can create, or (b) by the discretionary action of a monetary authority that can issue additional units of fiat currency.

Let’s consider first what would happen in case of an increased demand for liquidity by the public. Such an increased demand could have two possible causes. (There might be others, of course, but these two seem fairly commonplace.)...

Ooops, forgot the gif:
Penguin slaps another to the ground.