There have been whispers, or maybe it’s just wishful thinking, that the Federal Reserve might buy more long-term bonds, lowering interest rates and making housing more affordable. (You know that modified mortgage that didn’t work out so well? Have we got a deal for you!)
At 4.6 percent, 30-year mortgage rates are already at historic lows, yet housing demand cratered as soon as the government’s homebuyer tax credit expired in April. If you think lowering long-term rates and reducing the spread between short and long rates will stimulate the economy, think again. The steep yield curve is the most powerful thing the economy has going for it right now.
Not that there’s anything magical about two points and a line connecting them. It’s just that the yield curve, or what it represents, is possibly the best leading indicator of the business cycle. The Fed doesn’t need to fiddle around with the yield curve or plot another “Operation Twist,” a coordinated and ultimately unsuccessful effort by the Fed and Treasury in 1961 to lower long-term rates (to stimulate investment) and prop up short-term rates (to stem capital outflows). By holding the short rate at zero, which is not without its share of risks, the Fed is doing everything it can to avoid another recession.
How so? There’s “absolutely no possibility” of the nominal yield curve inverting with short rates at zero, says Arturo Estrella, professor of economics and department head at Rensselaer Polytechnic Institute in Troy, New York. Investors aren’t going to pay the government to hold their cash for 10 years.
Just because nominal long rates can’t go below zero, does that mean the U.S. won’t go into recession?
The yield curve has inverted prior to all of the last seven recessions, with no false signals since 1967, according to Estrella, whose website provides all kinds of research and data for the uninitiated.
Estrella uses the monthly average spread between the 3- month Treasury bill and the 10-year Treasury note to filter out the noise. The lead time between the appearance of a negative monthly spread and recession can be anywhere from three to 18 months. In the most recent instance, the spread turned negative in July 2006, and the U.S. economy slipped into recession in December 2007, according to the National Bureau of Economic Research, the official arbiter of the business cycle.
Under normal circumstances, the current spread of almost 300 basis points between short and long rates would be highly stimulative. Banks can borrow at next to nothing and lend to the U.S. Treasury, pocketing the difference. No fuss, no muss, no credit risk. The profit goes right to the bottom line, helping to recapitalize the banks, which will be in a better position to make loans to creditworthy borrowers.
Yet these aren’t normal times. Banks are either unable or unwilling -- perhaps due to expected losses on commercial real estate loans -- to lend. Demand for credit is still weak, too. Loans and leases at commercial banks have declined for 16 consecutive months, according to the Fed. That contrasts with solid increases in their holdings of Treasury securities.
To accuse banks of engaging in highly profitable “curve trades” in lieu of private-sector lending misses the point. That’s how it always works. When the economy goes into recession, the Fed lowers the short rate and steepens the yield curve. Private sector credit demand is weak while the government’s appetite is strong. Banks are happy to lend to Uncle Sam. Those loans expand the money supply, which gooses demand in the short run.
While a steep yield curve is a sign of an expansionary monetary policy, the Fed needs the banks to get in the game. Instead they’re content to earn the equivalent of the funds rate on the $1 trillion of excess reserves they are holding in their accounts at the Fed.
In this way, the current cycle resembles the aftermath of the 1990 recession when banks, burdened with losses on commercial real estate, weren’t able to expand their balance sheets.
So the best thing the Fed can do if it is concerned about a faltering recovery is keep the funds rate at zero. The short rate is the more powerful tool when it comes to moving the economy. (If it weren’t, why does every central bank in the world target a short rate?) That’s true even though most of us can’t borrow at the interbank lending rate of 0 to 0.25 percent.
“If corporations and banks can fund themselves at zero, credit would not be a problem,” Estrella says. “You could have slowdown for some other reason.”
Slowdown, yes; recession, no. That’s the message of the yield curve. Its track record is impeccable. It beats forecasters, econometric models, even the Fed, which seems to resist the inherent message in the spread.
For all those double-dippers still splashing around in the pool, it’s time to get out, towel off and learn to love a slow recovery.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)