yield curve

The Fed Keeps Twisting and Tells Us the Economy is in the Wind

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twistThe Federal Reserve will extend their Operation Twist past the June 2012 deadline and downgraded the economic outlook. Originally Operation Twist was $400 billion in Treasuries that were maturity dates of 3 years of less turned into T-bills with maturity dates of 6 to 30 years.

Here is the twist details from the NY Fed:

The Fed Does the Twist!

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twistThe Federal reserve announced Operation Twist, an action from 1961 where the Fed swaps out treasuries of short maturity lengths, for longer ones, all in an attempt to flatten, or twist the yield curve. From the Economist:

Operation Twist has long been considered a failure. Early studies found little impact on yields, vindicating those who argued that the price of a security depends only on expectations—of inflation, for example, or monetary policy—not its relative supply. Eric Swanson, an economist at the Federal Reserve Bank of San Francisco, disagrees. Previous studies, he reckons, didn’t properly isolate the influence of Operation Twist from countervailing factors. By studying the behaviour of bonds right around announcements related to Operation Twist, he concludes the programme lowered yields by 15 basis points in total.

From the FOMC statement:

New Deal Democrat vs. New York Fed on Economic Recovery and the Yield Curve

The New York Fed has just published a study on the predictive power of the yield curve in 3 months vs. 10 year Treasury bonds. (warning: pdf. For an html friendly summary with graphs, see Prof. Mark J. Perrys' claims that the NY Fed research means the recovery has already begun!).

The study updates previous research dating from the 1980's onward to the effect that a negative spread between the 3 month and 10 year Treasury yields (negative means 3 month Treasuries pay more interest than 10 year Treasuries) is means economic contraction - a recession - 1 year later. Conversely, a positive spread means economic expansion 1 year later.

Based on that, the New York Fed says that the recession is over! I disagree.

Respite R.I.P.!

If you've been reading me this year, you know I have made a few highly contrarian calls that turned out to be correct. Most importantly, that after picking up early in the year, demand destruction during the recession that I already believed was happening, would cause inflation to fade strongly later in the year. As a corollary to that, when others were counting the days until $130 a barrel oil would hit $200, I called it a top, and started a Countdown to $100 Oil that turned out to be too tame! I also was among the first on the blogosphere to note that China's bubble was bursting and that the recession would go global, and that the markets feared deflation.

But there is one call I made over a year ago which now can be given a well-deserved burial: the notion that there would be a "respite" in the ongoing "slow motion bust" at some point before the end of 2008.

Why Have the Markets Crashed?

The major US stock market averages have lost over 20% in two weeks alone, and over 10% just in the first four days of this week. Every single day, a major bank on some continent fails. We are in the midst of a full-fledged run on the financial system (I hasten to add: NOT your neighborhood savings bank) that by all definitions except the formal one of a 10% loss in a single day, should be called a crash.

I'll confess right here. I did not believe a crash would happen. In 1929 and again in 1987, crashes occurred less than 3 months after a fresh, exuberant high had been reached. It was exactly one year ago today that the DJIA reached its all time high of 14,165. Until 2 weeks ago, the decline was a slow grinding inexorable washing out much like 2000-2002 or 1973-1974. So much pessimism was already in the system that a crash seemed almost impossible. Then, after Lehman was allowed to fail, suddenly the emergency was upon us. Kudos to Lee Adler of the Wall Street Examiner who exactly cautioned a couple of weeks ago that his technical indicators were consistent with an imminent crash. He was right.

But that does not tell us WHY the market has crashed. This diary is somewhat stream of consciousness, and I'll add on graphs if I can later on, but for now, a narrative of why.

Hints of a year-end economic respite?

The recession is here (and has been since last December). It's going to hang around for a while longer at least. And layoffs and unemployment are almost certainly going to continue to increase right through election day, which is bad news for the people who will lose their jobs, but at least has the silver lining that it will increase the chances of Democrats doing very well indeed this November.

That being said, like seeing the green shoot of a crocus popping up above the ground at the end of January, I am seeing the first nascent signs that the economy may enter a period of respite by the end of this year, either growing very slowly or at least the pace of contraction slowing down to a crawl.

Surprise 2! Positive yield curves haven't always been positive for the economy

Readers of my diaries probably know that I consider the bond market to be one of the most solid indicators of what lies ahead for the economy. In fact, the stock market is a leading economic indicator, and the bond market leads even that.
In 2006 and 2007 the bond market went into a mild inversion, i.e., interest rates on short term bonds were higher than rates on long term bonds. This is a historically accurate indication of recessions about 12 months further out. It does appear that we have dutifully slipped into recession in the early part of 2008 (although we may not "know" it officially until the final revisions to economic numbers is made official - several years from now!)