Thursday, May 28, 2009

Spreading Lies

I discussed the treasury yield curve steepness (10-year minus 2-year) in a recent post titled How Steep Is My Valley. Today, some additional detail.

Long-term interest rates are jumping, with yields on 10-year treasuries now up to 3.73%. Apart from the significant impact on the real economy (e.g. higher mortgage rates ), this development is also placing into doubt the validity of a long-standing leading indicator, i.e. the yield spread between 10-year and 2-year treasury bonds (see chart below, click to enlarge).

Data: FRB St. Louis

Economists and market analysts commonly use this spread as a predictor of future economic activity and, thus, the direction of corporate profits; and from there, the prospects for the stock market. Indeed, it is one of the components of the official Leading Economic Index calculated by the Conference Board.

Right now the spread stands at 273 basis points (2.73%), the widest ever. Many analysts, therefore, are predicting the economy will turn around in short order and start growing smartly once more (the V- Gang). Ditto for corporate profits and, predictably enough, for share prices. which have been discounting exactly such a possibility for the last three months. To judge from the shop-talk in the various dealing rooms I contact on a regular basis, the 10-2 spread is the single most fashionable indicator right now.

I think this to be a grave mistake. I believe that, unlike other instances, the spread is widening because of two developments unprecedented in the history of the US (though common enough in other, less developed countries, in the past).
  1. On the short end, the Fed is engaged in massive monetary operations (quantitative easing) and is keeping short rates near zero.
  2. On the long end, the Treasury is bailing out financial and other corporations by promising to inject trillions of dollars it does not have and has to borrow. This massive supply of new Treasury bonds - present and upcoming - is putting upward pressure on long rates and placing the country's AAA credit rating in serious jeopardy.
Clearly, therefore, the widening of the spread is not due to fundamental economic strength. Instead, it is indicative of the rising risk premium that investors are demanding for lending the US government money for longer period of time.

For a better appreciation of this fact, look at he chart below: it's the 10-2 spread divided by the yield of the 2-year treasury, i.e. the spread as a percentage of the 2-year yield (today, 273 bp/97 bp = 2.81= 281 bp).

The premium demanded for lending long is at a very significant new record high, when measured relative to short-term rates. In my opinion, then, to interpret the 10-2 spread as a harbinger of an imminent V-shaped recovery is tantamount to "spreading lies"..

...and P.S.

Durable goods orders were announced today, up "more than expected" at +1.9% for the month. Here's the crucial detail: defence goods were up a whopping +23.2%. Without them the increase would have been +0.6%. Now.. do you suspect that some DOD orders were placed ahh.. shall we say.. opportunely? Nah...


  1. Always like to check your blog Hell.

    The gov statistics really are meaningless.

    The widening 10-2 spread has to be explained by the FED pumping liquidity in the short term and the inevitable inflation as a result until proven otherwise.

    Also, with the initial jobless numbers showing a rate of "decreasing acceleration," one would have to adjust the absolute numbers for the decreasing pool of workers still left with jobs. This makes the percentage of job loss higher.

  2. How Empire will continue financing its imperial sway will grow exceedingly interesting as the strain becomes increasingly unbearable and those military orders have to be curtailed.

    The anon hoping for an invasion of some-poor-country/Cuba may have to downscale his ambitions but when TSHTF there should be enough killing and raping domestically to keep him entertained; I wonder if he would like to volunteer some of his relatives for the cause.

  3. Thirty years ago my Mama came over here, to a Western European country, and was firmly (albeit delusionally...) convinced that because we didn't have clothes dryers (but then on the other hand we DID have the best health care on the planet at the time), she was in a third world country. (Sorry, third world...)
    Actually, I'm kind of interested in finding out when the IMF is going to step in and suggest a little...ah, structural adjustment for the bloated American budget.
    That will be very entertaining, I think.

  4. Debra wrote:

    "I'm kind of interested in finding out when the IMF is going to step in and suggest a little...ah, structural adjustment for the bloated American budget."

    I hope that was a joke. The IMF, despite the "international part of its moniker, is controlled by the U.S. so they will do nothing of the kind. Having said that, there will most certainly be further structural adjustment here in Freedom's Land, but it will be enforced from other quarters than the IMF.

  5. Sigh...Edwardo,
    You know, back in the GOOD OLD DAYS when I was a firmly convinced and staunch human rights defender, I thought that the international institutions were SUPPOSED to be for everyone...
    Of course when the realization that the BIGGEST human rights violation of all in the U.S. was the tacit assumption that the mother country made ALL the rules, but then refused to play the game by them, well, that kind of DAMPENED my enthusiasm for the game, you know what I mean ?

  6. Love your blog and read it religiously.

    I am not fond of your chart 10-2/2. It's giving a very radical picture that is completely driven by the absolute value of rates.

    300 bp is 300 bp whether rates are 14% (The 30 year 14's issued in 81) or 2%.

    I'm also inclined to worry about everyone getting so attached to the 10 year/ mortgage rate relationship. There isn't anything, really, that ties them. 30 years ago, they had similar durations, but waves of refinancing and hair-trigger refinance levels are severing that relationship. In the rough seas coming, it may not be relevant at all.

  7. Is there an economic term for when the price of necessary items (i.e. food) inflates and unnecessary items (i.e. everything else)deflates? Things seemed vaguely stable for a while in regard to mortgage rates/price of gold and now they're all wonky again.

    Wonky makes me nervous and twitchy.

  8. Maybe Los Yanquis are resented for all the devestation Tio Sam has bequeathed upon Latin America over the last 175 years.

  9. It's good to see America's "closest ally" helping it win more friends around the world. How can the US ever show its gratitude; oh I forgot, there's that $10M/day (not counting off-balance-sheet goodies slipped under the table).

  10. re:300 bp spread being the same at 14% or 3%

    This is simply NOT true. The risk/reward relationship is completely different because of the absolute bottom boundary of zero (0%) interest rates. Unless you seriously contemplate negative nominal rates, like some ivory tower academics out there...

    Also think of much higher rates: would you be willing to invest for 30 years at, say, 40% as opposed to 3 mos. at 37% ?

    All spreads are not created equal.

    Regards and thx,

  11. Thanks Hell.

    It is why I love you insight.

  12. "This is simply NOT true. The risk/reward relationship is completely different because of the absolute bottom boundary of zero (0%) interest rates."

    Well, you have access to data I don't, but just looking at your charts...when 30 year treasuries were at or around 14% we had a negative yield curve.

    So unless you can show me some magic that makes everyone far more logical at 37% than 14%, then i don't think you've made your case.