Sunday, June 18, 2017

The flattening yield curve

This is a great article from Josh Brown.  It's an article I'd like to think I would normally write.  He basically says to calm down about the flattening yield curve.  Economies can have years of healthy growth with flat yield curves, even if inverted yield curves are a sign of a coming correction.  This is an excellent point, and normally I'm more than happy to fight the perma-bears and the bubble-mongers.  But, at the risk of being shown a fool, "This time it's different."  (Maybe it's safe to use that phrase in defense of being a bear.)

First, the most significant reason long term rates are low is because we have constructed barriers to long term residential investment.  This is why GDP growth has been anemic, why the labor recovery was somewhat weak, and why there have been headwinds for consumption and balance sheet recovery.  Especially in working class neighborhoods, home prices are still 20% or 30% too low because we have destroyed owner-occupier demand in those neighborhoods, which creates real losses and introduces agency costs to tenancy while also harming working class balance sheets.


So, the reason for the flat curve is a lack of investment, and its already putting both real and nominal economic growth on crutches.

Second, real bank lending is already stagnant.  It has been for about 3 quarters.  This is usually a lagging effect and it points to my third point.

Third, the yield level may have a significant effect on the slope of the yield curve.  The zero lower bound creates non-normal distributions for expected future interest rates, which prevents the long end of the curve from flattening as much as it normally would.  In other words, there is option value in long term interest rates.  I know I am certainly much more willing to take speculative short positions on bonds when rates are very low.  There is a lot of skew here.

Notice how inverted the yield curve became in the late 1970s, when rates were high.  1990 and 2000 were pretty shallow recessions and in both the inversion was also pretty shallow.  But, the 2008 recession was more akin to the 1980-82 recessions, yet the yield curve inversion was much more shallow.  In the late 1970s, rates were around 10% to 15%.  In 2007, they were about 5%.  Today they are 1%.  I think it is pretty clear that a contraction will happen without a true inversion here.  The question is how much slope will we have when the natural short term rate starts to fall without a response from the Fed.  We could be there already.  If we get a couple of bullish head fakes, which is certainly possible in the inflation indicators over the next couple of months, the Fed might even push another rate hike.

I think the Fed's general stance, the broad demands for destabilizing monetary austerity, and these yield curve distortions make a contraction within the year probable.


  1. If you believe a contraction is probable, have you recently shifted your personal investments away from equities and toward bonds?

    1. I'm reluctant to get into the habit of sharing private information or of giving direct investment advice. The answer to your question is generally yes, but I'm probably not going to go into more detail than that. One reason I make these posts is to clarify my thoughts and to receive feedback on the positions I am taking or considering. IOW my money is usually where my mouth is. I don't know what the point would be, otherwise. I'm an investor, not a pundit, even if I occasionally play one.

  2. Hard to see a big upside, and easy to see a slowdown.

    I am trying not to become bearish with age, as I think that is a common trait. Also, making long faces about deontology and monetary policy is another gerontological trait--I think I dodged that one!

    I came across some figures recently (in my pen-for-hire work) that are common knowledge and public record etc.--and yet a bit of a shocker.

    The U.S. Census Bureau projects the U.S. total population will grow from 325.2 million in mid-2017 to 380.2 million by 2040, assuming current immigration levels of about 1.3 million net annually.

    In just a little more than the next 20 years, the United States will have to house another 55.0 million residents, equal to nearly a 17% expansion of its population.

    55.0 million more people in a generation!

    For every five U.S. residents who need a roof presently, there will be six in 2040. That is in 23 years.

    Rehabbed apartment buildings in high barrier-to-entry regions are probably good as gold. Actually, way better than gold.

    LA County is adding about 20,000 unit annually.

    Also: L.A. County has added 500,000 jobs since the bottom of the Great Recession.

    What could go wrong?

    1. Sounds like we're going to need a lot of macroprudential policies in order to keep those LA prices down. :-(

  3. MAA REIT rose recently even before rate hike. is it because the market expect slowdown and mild recession so new home supply will tumble while people still have shelter need will have to down grade to apartment making them high yield substitute for IG bond? It seems to agree with previous recession expectation like early 2016, but now even MReit are rising and that is difficult to explain since MReits lend short term and borrow long term to property owners. it is especially unusual as the fed said that they will reduce their mortgage security holding. may you share your thought on that? thanks.

    1. Yes. I agree these are interesting places to look. I'm no expert on them, but I think the equity REITS are more of a secular investment. They should continue to have high returns on equity as long as we keep obstructing home ownership. But, it seems like that potential might be generally priced into the stocks, and there might be downside risk if homebuilding recovers and rent inflation subsides. I like the mortgage REITs as a cyclical position. It looks to me like they don't tend to kick into gear until after the Fed Funds rate peaks and then begins to fall. It will be interesting to see if that reaction is earlier than normal here (possibly because some segment of the market agrees with my position) or if this is just movement from some other factors and they will pull back or remain in a range for a while.

  4. isn't mortgage reit profit rely on yield curve steepness? Why the price still keep rising? even if the market is predicting/expecting something, like fed stop the hike for a quarter or two, the yield curving isn't likely to steepen again. As a machine learning developer, I can see the productivity in software related area rises so rapidly that the unemployment is likely to keep the downward trend as software replaces mid-level decisioning making staff, leaving more budget for front-end low salary workers (so PCE remain stagnant). What's your view of that if this is actually the case and the FED sticks with the Philip curve while ignoring the PCE data? Personally, maybe due to the bias in my area, I am wondering if the consumer surplus produced by AI may be enough to bail out FED plunders for another year or two so I only reduced my position by a few percent.