BondSquawk

by Rom Badilla, CFA – Bondsquawk.com

June 8, 2010

In this article from The Economist, the author attempts to find the reasoning behind the decline of commodity prices from the recent highs. While it is established that the decline is indeed a sign of weakening demand, mostly from China and emerging economies, the author’s argument for a potential slowdown, stops at the fact that the U.S. Treasury yield curve is upward slopping. In other words, it is not inverted which typically suggest by research from the Federal Reserve, of an impending recession.

If commodities are a signal of an economic double-dip, do other markets support their message? Well, the Treasury 10-year yield has fallen from 4% to 3.3% in recent weeks and there has been the equity market correction. I would also point to the money supply numbers in the US and Europe, which have been flat-to-falling. The Lex column in today’s FT suggests this may be down to the end of QE.

What stops me from accepting this message entirely is the yield curve. It remains upward-sloping, with two-year Treasury yields at 0.8%. Normally, the curve inverts before a recession. Now one could argue that the curve is being distorted because central banks are holding short rates artificially low. But that require one to ignore a tried-and-trusted indicator; after all, the curve did invert before the 2008 recession.

Respectfully and while recognizing that he is spot on regarding falling commodity prices, I think the author misses the point on the yield curve. There are several consequences to an inversion similar to what we experienced in 2006 where the front end of the yield curve was higher than the long end.

In 1996, Federal Reserve Bank economists, Arturo Estrella and Frederic Mishkin wrote that the term structure of interest rates aka the yield curve is a strong predictor of a recession, surpassing leading indicators such as the stock market. Essentially, they have found through their statistical analysis, that the greater the inversion between short rates and longer term rates, the greater the likelihood of a recession within the next year.

The last inversion for the US, occurred mid 2006 through mid 2007. The inversion as indicated by the negative spread between the 3 month bill and the 10-Year Treasury lasted almost 11 months and averaged -30 basis points.

Specifically, in a typical upward sloping curve, banks borrow short with a lower rate and lend or invest farther out the curve at a higher rate. For example, banks use excess reserves from overnight deposits and grant a loan as a mortgage or home equity loan which has rates correlated to the long end of the maturity spectrum. This spread between the two allows a bank to make money.

So with an inversion, this construct is not economically viable as it prevents a means for banks and other lending institutions to make money. This in turn leads to less money creation via extending credit and a slow down in growth and production ensues. An inversion doesn’t cause the recession per say but it is a bank’s response or lack thereof the kick starts it. Furthermore, the inability to use this strategy leads financial institutions to resort to other means of making money such as excessive risk taking or by “reaching for yield”. by investing in riskier products like subprime. This can blow up in their face as 2008 illustrated with the real estate market meltdown. Hence, that is the more relevant focus that our author from The Economist fails to delve into to.

Sure, the argument can be made that the last inversion with all the resulting forces of derivatives, financial innovation, and excessive risk taking, created one big recession even with the respite of growth in the first half of 2010. I will certainly not dispute that since I have argued that the “recovery” was questionable at best due to fiscal stimulus which is on the verge of running out.

In either case, banks today are not lending as the symptom or end-result from the aforementioned environment is prevalent. Money creation via loan growth is at a standstill. Either banks are too scared to lend due to higher default expectations or borrowers refuse to do what they have always done, which is borrow. The latter may stem from a willingness to save and paydown debt or the uncertainty in employment may lead to conservative approaches to borrowing. While Ben Bernanke continues to scratch his head looking for a cause, the fact remains that there is no loan growth as the economy deals with a “balance sheet recession”. That is why there is no need to look at the yield curve for signals to our future. The economic slowdown is already here.