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Steep Yield Curve: Sign of Economic Recovery?
A closer looks at the steepening bond yield curve reveals why "this time, it's different."
Below is the first article from a new, weekly feature inside both Services called "Weekly Report," written by EWI's analyst Jason Farkas. Enjoy.
Weekly Report
Posted On: Fri, 12 Jun 2009 16:00:30 GMT
Mixed Signals
The recent sell-off in the 30-year US Treasury bond has created a very steep yield curve that, in normal times, would seemingly help stimulate increased borrowing, lending and economic activity. But, today’s times are anything but normal, as a Grand Supercycle decline in US equities (which reflects the concurrent decline in social mood) creates more than a few “once in a lifetime” occurrences. We’ll examine the yield curve and the signals it’s giving Elliotticians now.
Typically, an inverted yield curve is a harbinger of a recession. When longer term rates are lower than shorter term rates, banks aren’t encouraged to attract depositors or to lend because there isn’t much “spread” between their costs (interest paid on deposits) and their profits (interest received from lending activities). When a yield curve is inverted -- as it was in 1969, 1973, 1979, 1981, 1989, 2000 and 2006-7 -- a significant equity and economic decline results about half of the time.
Conversely, when a yield curve is very steep, as is the case today, banks are encouraged to lend because profit margins are high. Current short-term interest rates on the 13-week T-bill are at 0.17% while the 10-year Treasury note is at 3.86%. This spread suggests that banks should be more inclined to lend today because of the difference between borrowing short and lending long. The trouble is that most banks don’t have the excess capital to lend now because their balance sheets and capital ratios have been impaired dramatically by the housing and credit crises. In addition, since frugality is now in style (notice that former “fashionistas” are becoming ”recessionistas”), banks’ customers are less inclined to borrow.
Those looking to believe that the worst of the economic turmoil is behind us can point to the steep yield curve as evidence that blue skies are ahead. But, in this instance, the low yield on the 13-week T-bill suggests something entirely different. It suggests that investors’ desire for safe, liquid, AAA assets hasn’t subsided, and that demand for T-bills is overwhelming the supply.
The 0% Fed Funds and T-bill rates have helped create a Treasury yield curve that, in this case, is misleading -- as it has sometimes been in the past. Towards the end of 2001, the United States also had a steep yield curve, similar to the current environment. In swift fashion, the Fed had taken the overnight Fed Funds target from 6.5% at the beginning of 2001 to 1.75% by year’s end to combat a potential recession. On December 31, 2001, the 10-year T-note closed at 5.03%, which meant that a steep yield curve was in effect. Even though a steep curve existed, the S&P 500 didn’t bottom until 10 months later in October 2002, and it had another 31% to decline. So, the steepness of the yield curve couldn’t prevent another leg of a bear market during most of 2002.
This example shows yet again that the tools that policy makers use are at the mercy of mass psychology. Social mood, which is EWI’s term for mass psychology, currently suggests that we should prepare for an even more glaring example of the steep yield curve’s inability to come to the economy’s rescue.
Today, a Grand Supercycle decline in US equities accompanies a massive supply of T-bonds coming to market. In the market forecasting business, we try to look around corners before reaching them. In this case, we’re suggesting that the United States is going to see an equity and bond decline, with a further steepening of the yield curve, because the demand for US T-bills will continue to be high. As such, many market watchers will incorrectly suggest that markets are ready to bottom due to something that “should” allow an economy to function properly: a steep yield curve.
A chance reading of a book on technical analysis and the Austrian school of economics eventually led Jason Farkas, CMT, to Elliott Wave International. An Arizona State University graduate, prior to joining EWI Jason worked for 14 years as a futures, options and equity trader. Jason has been tutored by some of the best investment minds, including legendary trader Dick Diamond. Jason is an avid student of market psychology, with a keen interest in proper position-sizing and risk controls, which help to differentiate gambling from speculating in investment markets. You can read Jason's Weekly Reports in EWI's intensive Currency and Interest Rates Specialty Services.