Notes From Underground: “Both Sides Now”

This is a tribute to N.B. and his continued effort to search for perspective (and his love of Joni Mitchell):

      I’ve looked at life from both sides now
      From up and down and still somehow
      It’s life’s illusions I recall
      I really don’t know life at all
I bring this up because last night’s blog elicited a great deal of comment about the 2/10 yield curve. Everything we do in trading and investing is about perspective and so much of our thought is time-based. A person using a 10-minute chart sees the financial and commodity markets from a much different series then a person relying on a daily, weekly or monthly horizon. Therefore, tonight I am posting an eight-year chart of the 2/10 yield curve, which includes the period prior to the onset of the Great Recession, as well as the Fed’s large-scale asset purchases. Before the housing crisis, note that the 2/10 curve had actually inverted, which is the paradigm of an ultra-flat curve. As the FED cut rates in an effort to “prime the liquidity pump,” the Fed was able to steepen the curve as short-term yields fell and long yields began to moderately rise in the view that the Fed would be successful in its attempt to stimulate the economy.

2/10 Yield Curve Since 2006

The first QE was activated in late 2008 after it appeared that merely cutting interest rates was not enough to prevent the mass liquidation of financial assets. So the Fed begins purchasing mortgage-backed securities and U.S. Treasuries to provide ample liquidity to the financial system. The failure of the economy to respond with more robust growth led the FED to do more QE and so we got QE2 in November 2010 and an open-ended QE3 in September 2012. The advent of QE3 was necessitated by the European sovereign debt crisis, which caused a global flattening of yield curves as frightened European investors and global money funds were terrified of buying any short-term debt instrument for fear of a European sovereign failure. European two-year note yields soared and U.S. long-term yields dropped as fear forced investors to relatively safe harbors. The U.S. and European yield curves made their flattened on the same day (July 24, 2012) for the next day ECB President Draghi made his now famous statement–“We will do whatever it takes”–to ensure the solvency of the European peripheral nation and of course the euro currency.

The low on the U.S. 2/10 in July was a relatively flat 117 basis points. As the global economy steadied and the Fed increased its balance sheet, the yield curve has again steepened to the current level of 230 basis points. When the financial pundits warn of flattening it’s with no perspective longer than 24 hours. I maintain that the curve is at a robust level and while flatter than three months ago, it is far from flat. As the Bloomberg chart shows, the average level for the last eight years is 160 basis point. Is this a flat curve? Hardly. While I believe the yield curves are very directional, I want us to maintain perspective … “From Both Sides Now.”

***Tonight the BOJ will announce its interest rate policy. While there will be no change in the current 0.10% rate some analysts believe that the BOJ will bring forward its asset purchase programs to help the markets adjust to the recent three percent increase in the sales tax. While the Abe Government would like to see Japanese investors reallocate their portfolios to equities from bonds, it may  fall upon the BOJ to be the initiator of increased stock purchases. The BOJ is authorized to purchase some types of Japanese equities so be mindful of the NIKKEI and other stock indexes to judge the impact of any effort by the BOJ to increase liquidity by bringing forward its stock purchases. The Nikkei closed near its 200-day moving average today so the markets are waiting to see if the BOJ can have a similar effect to the FED in causing a change in the PORTFOLIO BALANCE CHANNEL. Will Japanese pension funds and other investors come to believe that the 20 years of deflation are ending and that bonds are a miserable investment in the time of rising inflation? The Abe Government has much vested in the “three arrows” strategy of creating economic growth and this policy is at a critical juncture as growth has begun to dissipate. The BOJ under Governor Haruhiko Kuroda has been a willing participant in the Abe policy and has its credibility on the line. What say you Mr. Kuroda?

***We are awaiting election results from Canada, especially Quebec. The Canadian dollar has performed well during the last five trading days so its appears the Liberal Party will prevail and the secessionist Parti Quebecois will be handily defeated, but do not have any hard results as of yet.


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9 Responses to “Notes From Underground: “Both Sides Now””

  1. Shocked to Find Gambling Says:

    Yra- Great post….I almost asked you to put up a 2/10 chart yesterday.

    I have one more point to add on perspective. The effect of FED actions have to be viewed relative to the market zeitgeist.

    The FED tightens, and we expect the yield curve to flatten, but if the tightening is considered inadequate to slow future inflation, the yield curve can (and has) steepened.

    The same is true for easing. We expect a steepening, but if people take the easing as a sign the economy is really weak, and want to lock in rates for the longer term, the market can flatten on a FED easing.

  2. Shocked to Find Gambling Says:

    I meant to say ” the yield curve can flatten on a FED easing”.

  3. yra Says:

    shocked –the classic study is when the British were busy cutting rates ibn the late 80s and the short end dropped and the long end yields rose as the Bank Of England was deemed to be acting irresponsibly—I have the scars from that as I was long gilts for four successive cuts and lost money and the curve can flatten is the fed is deemed to be behind the curve so to speak—so you are correct

  4. Shocked to Find Gambling Says:

    Yra- I believe in the late Seventies, the FED was tightening, and the yield curve steepened (initially, later it inverted).

    The FED is usually behind the curve……….. if they were prescient, they would be trading SPOOS at the CME.

  5. yra Says:

    Yes–correct on both counts and that is because it took Volcker to squeeze funds high enough and the curve had to invert for the Fed to find out when they were going to be right

  6. Chicken Says:

    Perspective is extremely useful. Seems unwise to bet against a guy with a spectacularly crusty name such as Kuroda-san, he might slice you into pieces.

  7. Shocked to Find Gambling Says:

    Yra- Would you give a comment on the significance of the price movement in the Yuan and Baltic Dry Index for the last month or so?

  8. Dustin L. Says:

    Yra- You have exposed me to studying the yield curve more than anyone, and for that I am very thankful. I have been of the opinion that the 10-2 curve in the US would flatten as current growth expectations catch up to the forward expected growth levels. The relatively steep yield curve is also indicative of the very exaggerated time inconsistency in this current market demanding a relativly large premium to engage in long-term deferring of consumption. See share buybacks and the focus on dividends in equities markets for evidence of this behaviour rather than reinvestment into the business’ growth and competitive advantage. Since 1988 the median spread has been very close to 100 basis points (97.43 to be exact) and the average has been right around 116 basis points. With us standing currently at around 230, as you have said we are hardly flat here, and stand close to the average over the past year of 222 (252 day SMA). What could be key to watch here is if the curve does continue to flatten it could signal that some of the poor capital allocation and destructive capital consumption could come home to roost if the curve flattens too much and the so called “animal spirits” are reversed. I am not sure it is here yet but, definitely something to watch it would seem. Rising short rates seems a likely culprit more than falling long rates. I am also finding the flattening in the 30-10 UST spread interesting right now. It has flattened more aggressively than the 10-2 and I would be curious to hear your opinion in the long end of the curve?

    All the best,

  9. yra Says:

    Dustin–see tonight’s post in reference to Fed credibility

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