Investors grow wary as difference between yields on two- and 10-year Treasurys reaches narrowest point since 2007
The gap between short- and long-term Treasury yields is at its narrowest in more than a decade, reflecting investors’ confidence that the Federal Reserve will maintain its current pace of interest-rate increases despite ongoing skepticism about the longer-term outlook for economic growth and inflation.
The difference between the two-year Treasury yield and the 10-year Treasury yield, known on Wall Street as the 2-10 spread, settled Tuesday at 0.428 percentage point, its tightest since 2007. Two-year yields tend to rise along with investor expectations for tighter Fed interest-rate policy, while longer-term yields are more responsive to sentiment about prospects for the economy.
.. John Williams, president of the Federal Reserve Bank of San Francisco said Tuesday in Madrid that while an inverted yield curve is a “very clear symbol that the economy’s about to go into a recession,” some flattening is typical when the Fed raises rates and he doesn’t anticipate an inversion of the yield curve.
.. Some investors are concerned the flattening curve suggests the Fed could raise interest rates more than the economy can handle.
.. On the other hand, higher short-term yields suggest investors have confidence that inflation will reach the Fed’s 2% target, but stable longer-term yields suggest a lack of concern that policy makers will lose control
A Decade After Bear’s Collapse, the Seeds of Instability Are Germinating Again
A big financial-firm collapse in near future is exceedingly unlikely, but another crisis isn’t
.. Bear and Lehman were the manifestation of deeper economic forces that since the 1970s have produced crises roughly every decade. They are still at work today: ample flows of capital across borders, mounting debts owed by governments, corporations and households, and ultralow interest rates that nurture risk-taking in hidden corners of the economy.
By the early 1980s, though, deregulation had allowed capital to flow freely within and across borders and crises became a regular occurrence: the Latin American debt crisis that began in 1982,
- the U.S. commercial real estate and savings and loan crisis of the 1980s,
- the Asian and Russian financial crisis of 1997-98,
- the dot-com bubble of 1998-2000,
- the U.S. mortgage crisis of 2007-2009 and
- the European sovereign debt crisis of 2009-2013
.. Bear was both facilitator and victim of a housing bubble inflated by low interest rates and huge inflows of foreign capital—a “global saving glut” as then-Federal Reserve Chairman Ben Bernanke put it.
.. It arranged mortgages that financed the housing bubble while borrowing heavily with short-term IOUs.
.. When those mortgages went bad, Bear’s creditors yanked their funds—a de facto run on the bank.
Most of the regulatory effort since has been to ensure the largest financial institutions such asJPMorgan Chase & Co., which bought Bear Stearns in a fire sale brokered by the Fed, don’t succumb to anything similar:
- thicker buffers of capital to absorb losses,
- more reserves of cash and liquid assets to pay off skittish creditors,
- restrictions on trading and compensation that incentivize risk-taking, and
- new procedures for winding down failing institutions without taxpayer bailout or a chaotic bankruptcy.
Hyun Song Shin, research chief at the Bank for International Settlements, warned in a 2014 speech against the tendency to “focus on known past weaknesses rather than asking where the new dangers are.”
.. bond markets are growing at the expense of banks in supplying credit, enabling business and government debt loads in many countries to surpass their precrisis peaks.
.. Emerging markets have borrowed heavily in dollars, which leaves them vulnerable should the dollar’s value rise sharply
.. Total U.S. debt, at around 250% of GDP, still stands at crisis-era peaks while debt levels in China have caught up and passed the U.S.
.. Crises surprise because they usually start with an assumption so sensible that everyone acts on it, planting the seeds of its own undoing:
- in 1982 that countries like Mexico don’t default;
- in 1997 that Asia’s fixed exchange rates wouldn’t break;
- in 2007 that housing prices never declined nationwide; and
- in 2011 that euro members wouldn’t default.
.. the equivalent today might be, “We will never see higher inflation or higher growth.” If either in fact occurs, the low interest rates that have raised household stock and property wealth to an all-time high relative to disposable income won’t be sustainable.
.. A 1.5 to 2 percentage point increase in real interest rates, which he isn’t forecasting, would be small by historical standards but could potentially make the debts of Italy or Portugal unsustainable.
.. Central banks know this, of course, which is one reason they are wary of raising interest rates too quickly—while nervous that if they raise them too slowly, the problem will get worse.
The Macroeconomics of Trade War
diverting demand equal to 3 percent of GDP from foreign to domestic products would not increase US output by 3 percent relative to what it would have been otherwise, let alone the 4.5 percent you’d expect if there’s a multiplier effect. Why? Because the US is close to full employment.
.. a 3 percent rise in output relative to trend would reduce unemployment about 3 times that much, 1.5 percentage points. And that just isn’t going to happen.
.. What would happen instead is that the Fed would raise rates sharply to head off inflationary pressures (especially because a 20 percent tariff would directly raise prices by something like 3 percent.) The rise in interest rates would have two big effects. First, it would squeeze interest-sensitive sectors: Trump’s friends in real estate would become very, very unhappy, as would anyone who is highly leveraged (hello, Jared.)
.. Second, it would drive up the dollar, inflicting severe harm on U.S. export sectors. Greetings, farmers of Iowa!
So protectionism wouldn’t do very much to reduce the trade deficit, even if other countries didn’t retaliate, and would inflict a lot of pain across the economy. And that’s without getting into the dislocations caused by disruption of supply chains.
.. Add in the fact that other countries would retaliate – they’re already drawing up their target lists – and the fact that we’d be alienating key allies, and you have a truly terrible, dumb policy idea. Which makes it quite likely, as I see it, that Trump will indeed follow through.
A Hedge-Fund Titan Puts Away the Punch Bowl
Ray Dalio of Bridgewater sees Americans’ debt as a coming drag on growth and markets
.. While he doesn’t see another crisis in the offing, he does see the same underlying stresses at work: Americans have accumulated far more debt than they have assets and income to support.
.. Not only will this drag on growth and markets, it will leave the economy acutely vulnerable to higher interest rates. The relevant parallel, he says, is not the early 1930s, when the economy imploded, but the late 1930s when the Federal Reserve tightened monetary policy and inadvertently extended the Great Depression. Today, the central bank must balance the short-term need for higher interest rates to contain inflation against the long-term need for low rates to work off the debt overhang and sustain high asset prices.
.. “It may not be a problem in the next year or two, but the risk of not getting it right increases with time.”
.. “We ‘finance people’ see the world very differently from the way economists do,”
.. The views of finance people tend to be shaped more by trading experience than by formal economics. They assign much more weight to financial factors such as debt, asset prices and cash flow than do economists who emphasize “real economy” factors such as employment and investment
.. Finance people are wary of how macroeconomic data obscures crucial details of individual companies and households. Some economists do think like finance people, such as former Fed Chairman Alan Greenspan, but they are in the minority.
.. since the 1970s, inflation-adjusted interest rates have steadily declined while investors have accepted ever lower compensation for risks such as bankruptcy, recession and volatility (i.e. the “risk premium” has declined). This directly raises asset values and indirectly lifts growth by spurring borrowing.
.. His team estimates this has contributed three percentage points a year to stock returns since the 1970s while boosting private and government debt to 325% of gross domestic product.
.. In 2007, Mr. Dalio’s team concluded that the cost of servicing Americans’ debts was growing faster than their cash flows, creating the conditions for a crisis.
.. By slashing short-term interest rates to zero and buying bonds to push down long-term rates, it engineered the right combination of economic growth, debt write-offs and low interest rates necessary to start the painful process of “deleveraging,” or working off all that debt.
.. it can’t raise them much either, or debt servicingwould swamp cash flow and asset prices would sink. Thus Mr. Dalio foresees years of low interest rates, and while he thinks stocks are appropriately valued, he thinks returns to a typical stock-bond portfolio over the next decade will be around zero after inflation and taxes.
.. his biggest worry is that lower corporate taxes and higher stock prices do nothing for the bottom 60% of households who own almost no assets and whose stagnant wages are the mirror image of expanding profit margins, feeding resentment and political polarization. Says Mr. Dalio: “If we do have an economic downturn, I worry we will be at each other’s throats.”