Wednesday, February 16, 2005

Yield curve puzzle.

There's lots of speculation over why long term bond yields aren't budging despite the Fed moves and why the yield curve appears to be flattening, especially since the yield curve is one of the best predictors of growth or recession in 9-12 months.

Is the bond market predicting an economic slowdown or that we are nearing the end of the current up-cycle? [Credit spreads near lows though, which doesn't support this idea.] Is foreign central bank bond buying as they try to hold down their currencies driving down these yields? Is there some type of blow up [ala Long Term Capital] in the wings? Is the 'carry trade' driving it down? Does it reflect the fact that bond investors believe the Fed has control of inflation?

The most interesting speculation I have read recently comes from Stephanie Pomboy of MacroMavens, interviewed [$] a few weeks ago in Barrons:

"Q: That's why interest rates will remain stable?
A: It strikes me that the yield curve might be sending you the signal that basically this is an economy that just can't handle significantly higher long rates. We've gotten to this point on the back of consumers' borrowing, and they are extremely extended and while employment is picking up, it's still not sufficient. I always picture that scene from A Few Good Men where Jack Nicholson says: "You can't handle the truth!" And I'm thinking we just can't handle higher rates. I mean that's it.

Q: The economy has a very low threshold of pain for higher rates?
A: I think it takes less and less of an increase in rates to snuff out economic activity, and it seems like a statement of the obvious. I mean, we've got more and more levered, of course, and it would take less and less of an increase in rates to slow this whole consumption engine down. Consumer credit or cheap credit is the stuff that keeps this economy moving. Raise the price of that, and we're going to move a lot slower. I think that is in part what the yield curve is saying is that this is an economy that's built on a continued supply of cheap credit, and if we want to keep moving forward, we can't let long rates move significantly higher."


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