Lot's of articles like these going around about why the inverted yield curve isn't a concern any more. Basically it's due to foreign inflows, not threat of recession.
Of course this is what they said about the inverted yield curve in 2000, but maybe this time is different.
Also, Paul Kasriel admits to misinterpreting the inverted yield curve last time around, so presumably he didn't call the 2001 recession.
If profits do decline, and i stress DO, then it's very significant for almost every major stock index around the world, considering the earnings of most major country indices are dominated by financial institutions. For another view, S+P recently commented that the yield curve doesn't matter.
ac, one thing we know about the inverted yield curve is it will pressure bank profits and make some banks take on more risk in search of profits. The FDIC had an interesting analysis last November about the heavy (and risky) concentration of CRE and C&D loans at mid-sized institutions:
Regulators continue to note increasing concentrations of C&D and CRE loans to capital, especially at institutions with total assets between $1 billion and $10 billion.
Lower profits and more risk is not a great combination.
ac, one thing we know about the inverted yield curve is it will pressure bank profits and make some banks take on more risk in search of profits.
I don't know much about banking - is it correct to say that banks are basically making their money by engaging in a carry trade spanning opposite ends of the yield curve (i.e borrow at short rates, lend at long rates and pocket the difference)?
ac - that is the theory. In effect, recent net interest margins have been such a problem that a great deal of actual profit for many banks comes from fee income generated in one way or another.
is it correct to say that banks are basically making their money by engaging in a carry trade?
Yep.
This has been another installment of My Assets Are Your Liabilities: Banking for the Civilian. In the next chapter, we will discuss why Prime Rate is so high if these are supposed to be the "best" customers.
Somewhat off topic, but I thought this post I just put up was germane to the whole mortgage lending/standard tightening issue. Here's the text (I also have a chart available on my blog) ...
RealtyTrac just released its latest foreclosure report for January 2007. FCs were up 19% month-on-month from December to 130,511. ThatÂ’s the biggest MOM gain since August 2006, and it leaves the foreclosure count at a new high. This chart shows the history of the indicator, which I only have data for going back to 1/05.
If there was any sliver of a silver lining, it's that the year-over-year rate of increase was down to +25.1% from +34.9% a month earlier. The biggest YOY increase in any given month was November 2006 (+68.1%). But that's not saying a lot. The fact is, this mortgage delinquency/foreclosure problem is going to be with us for quite some time.
Lot's of articles like these going around about why the inverted yield curve isn't a concern any more. Basically it's due to foreign inflows, not threat of recession.
And I think they are absolutely dead nuts right on. Two years a go I wouldn't have even considered it... but now (after having read Setser everyday in parallel to this blog - absolutely).
And it wasn't an issue in 2001 - this is a recent event (or exacerbated recently... a little before & a lot now).
But the the things the bulls have to realize (or should at least consider)... is this 'condition' could be like the Monsoons... maybe tomorrow PBoC doesn't think it needs all those T-Bills & MBS. Then what?
The yield curve won't be negative anymore THATS for sure and I don't think that would be such a good thing either (with the whole curve rocketing up).
Maybe banks will make money again but they would end up being about the only ones...
I'm not a big believer in 'its different this time' on general principals... But when faced with evidence like the FCB reserve growth covered over at Setser's Blog... Its awfully hard to not notice there is a NEW guest in the living room... and he's awfully large and hairy.
But that still doesn't make it easier on the banks... so what do they do? Go after the international 'carry trade' instead? Mix a little currency risk in with the interest rate risk? Regulators oughta love that.
Lot's of articles like these going around about why the inverted yield curve isn't a concern any more. Basically it's due to foreign inflows, not threat of recession.
And I think they are absolutely right... foreign inflows ARE affecting our credit markets and shifting the yield curve especially on the long end.
And this is fairly new - it didn't used to happen a lot before the 1997 Crisis.
And there is good evidence for this 'it is different this time' scenario too - read Setser's Blog on the huge increase in FCB reserves worlldwide... most held in dollar denominated debt instruments. Getting harder and harder to ignore the new guest in the room... a big hairy guest.
How much is the long end pushed down as a result? Who knows - I remember reading somewhere (after one of AG's testimony before Congress maybe)... something like a pt and a half.
That would put the banks at quite a handicap if they are limited in their geography as to where they can get the 'low end' on the carry - eh?
So what's next, let the banks go direct to China to get their carry? After all we're getting everything else over there.
And nothing like letting them add currency risk to interest rate risk. After all, what's a little more risk in an ocean of it?
CR - Sorry for the sorta double post - Halo appeared to eat the first one & then flipped me a 404... it didn't show up when I reloaded so I recomposed & resent.
Mike in FL,
Your blog doesnt have a e-mail link so this is the best way to contact you. I was wondering if it would be ok for me to use some of the graphs for your blog in my strategy report (properly footnoted of course). I would be happy to send you a copy if you are interested. E-mail me at dvandijk@zacks.com,
Thanks,
Dirk
And I think they are absolutely right... foreign inflows ARE affecting our credit markets and shifting the yield curve especially on the long end.
Well, anybody making the case that inflows are responsible for the inverted yield curve have to explain why the yield curve wasn't inverted prior to mid 2006.
In re: bank profits, all the derivatives in the world don't erase the fundamental economic truth of banking: borrow short, lend long. In a flat-yield-curve environment, that eventually starts to bite.
Well, anybody making the case that inflows are responsible for the inverted yield curve have to explain why the yield curve wasn't inverted prior to mid 2006.
It wasn't inverted until mid-2006, but it certainly was acting atypical long before that. I believe the first signs of inversion were last January (the 2-yr and 10-yr if I recall). And it was flat long before that.
The 10-yr has been remarkably stable since the Fed started tightening (remember 'conundrum'). It finally inverted mid-2006 because the Fed pushed the short-term rates high enough.
Steve's got it right... the 'conundrum'. It wasn't inverted because both ends of the curve way 'low'... Fed started bumping the short end & the PBoC, BoJ & others said 'no thank you very much'.
And all during that time reserve growth has accelerated - throw the Gulf States & Russia & Brazil in with the Asians.
The question isn't did they have an effect... it is more how much & how long. The last one being the most important.
Steve's got it right... the 'conundrum'. It wasn't inverted because both ends of the curve way 'low'... Fed started bumping the short end & the PBoC, BoJ & others said 'no thank you very much'.
I still don't grasp why foreign inflows would distort the shape of the yield curve. Traditionally, longer dated debt pays more because of increased interest rate risk. Why would foreign inflows change that?
Today I see a 2-year note yields 4.94% while a 10-year note yields 4.80%. Why would anyone accept a lower yield from a riskier security? And why is this perverse prediliction somehow peculiar to foreigners?
It seems to me it can't be a supply problem (otherwise the yield on the 2-year would go down).
I certainly can see how foreign inflows would push down yields in general... but why long rates specifically?
ac - You have to look at it from their point of view. The US 10 year bond yields 4.8% - more than the 10 year Euro at 3.5% and also the 10 year Japan at 1.7%.
You are a Japanese or European central bank or an insurance company and you have long term obligations, what is your choice considering the US Fed is near the end of interest rate increases, the Euro Fed is in the middle and the Japanese Fed has barely begun.
Furthermore, they anticipate that when the US Fed is finished hiking short rates, the US economy will slow and the 10 year US bond will appreciate - a capital gain in addition to the highest yield available.
Many investors have a duration preference. However, many also look to maximize their return by shifting along the duration line. So an influx of long duration investors should be offset by others who are more opportunistic. The yield curve should retain its slope.
Why accept a lower rate for a longer duration? Because you expect rates to decline and want to lock in before it happens. Or you are an opportunistic investor looking for the capital gain as described by Tennis_8 above.
The Yield curve is inverted because the short end is artificially high due to market intervention (manipulation) by the Fed. High short term rates choke the economy and cool inflation. A strong yield curve inversion indicates an unfavorable environment for business borrowing, and leads to recession.
I still don't grasp why foreign inflows would distort the shape of the yield curve. Traditionally, longer dated debt pays more because of increased interest rate risk. Why would foreign inflows change that?
Even MORE important than return is getting the damn money placed in USD and not having to deal with it again for a while.
China runs something like a $20-30B surplus every month... according to Setser something like 80% or more goes into USD denominated 'something'... mostly debt but probably some equity too.
The LAST thing they want to do is have the damn things mature soon & have to reposition them... but they also want a liquid maturity if they do have to sell... so they want to buy the longest yet most common (liquid) maturities out there - the 10 year and some 5 year. And MBS.
They buy so damned many of them they drive the price up & the yield down!
And they could careless about minor reserve losses (say 5-10%) resulting from this distortion as long as their objective of currency stabilization (pegged RMB to USD) is met so they can continue to grow their export market.
Minor reserve losses are just the price of 'doing business'. If the RMB skies - they'll have way bigger problems than a few billion in lost reserves... they might end up with a revolution.
The problem we all make is we think like 'us'... not like 'them'. Put your head in their problems & you see why they do what they do.
However - it is getting so out of balance that the losses could mount to a level above their acceptable pain threashold... that is what happened to the Japanese leading up to Plaza... but the effects after Plaza weren't so much fun either... and they didn't have 100s of millions of hungry peasants looking for a better life.
Interesting hardly describes it - it will be the story that defines this whole century.
Thank-you, Mike_in_Fl, for posting the link to your excellent chart "Foreclosures keep on climbing".
I've been trying for days to drive-home an important point about the recency-bias that's so prevalent here and how it can lead to spectacularly-wrong conclusions, but you made my case with a single chart.
Second!
Lot's of articles like these going around about why the inverted yield curve isn't a concern any more. Basically it's due to foreign inflows, not threat of recession.
Of course this is what they said about the inverted yield curve in 2000, but maybe this time is different.
Also, Paul Kasriel admits to misinterpreting the inverted yield curve last time around, so presumably he didn't call the 2001 recession.
Deja Vu?
If profits do decline, and i stress DO, then it's very significant for almost every major stock index around the world, considering the earnings of most major country indices are dominated by financial institutions. For another view, S+P recently commented that the yield curve doesn't matter.
ac, one thing we know about the inverted yield curve is it will pressure bank profits and make some banks take on more risk in search of profits. The FDIC had an interesting analysis last November about the heavy (and risky) concentration of CRE and C&D loans at mid-sized institutions:
Regulators continue to note increasing concentrations of C&D and CRE loans to capital, especially at institutions with total assets between $1 billion and $10 billion.
Lower profits and more risk is not a great combination.
Best Wishes.
i've been waiting for debt service to turn into a problem for more households, but even i didn't expect a one quarter jump in non-performing: ye gods!
LJ, could you forward that email to me? Calculated Risk
Best Wishes.
ac, one thing we know about the inverted yield curve is it will pressure bank profits and make some banks take on more risk in search of profits.
I don't know much about banking - is it correct to say that banks are basically making their money by engaging in a carry trade spanning opposite ends of the yield curve (i.e borrow at short rates, lend at long rates and pocket the difference)?
ac - that is the theory. In effect, recent net interest margins have been such a problem that a great deal of actual profit for many banks comes from fee income generated in one way or another.
is it correct to say that banks are basically making their money by engaging in a carry trade?
Yep.
This has been another installment of My Assets Are Your Liabilities: Banking for the Civilian. In the next chapter, we will discuss why Prime Rate is so high if these are supposed to be the "best" customers.
Somewhat off topic, but I thought this post I just put up was germane to the whole mortgage lending/standard tightening issue. Here's the text (I also have a chart available on my blog) ...
RealtyTrac just released its latest foreclosure report for January 2007. FCs were up 19% month-on-month from December to 130,511. ThatÂ’s the biggest MOM gain since August 2006, and it leaves the foreclosure count at a new high. This chart shows the history of the indicator, which I only have data for going back to 1/05.
If there was any sliver of a silver lining, it's that the year-over-year rate of increase was down to +25.1% from +34.9% a month earlier. The biggest YOY increase in any given month was November 2006 (+68.1%). But that's not saying a lot. The fact is, this mortgage delinquency/foreclosure problem is going to be with us for quite some time.
Interest Rate Roundup
In the next chapter, we will discuss why Prime Rate is so high if these are supposed to be the "best" customers.
Hey even I know the answer to that one... 'best customers' are the ones you think will actually agree to pay it.
Lot's of articles like these going around about why the inverted yield curve isn't a concern any more. Basically it's due to foreign inflows, not threat of recession.
And I think they are absolutely dead nuts right on. Two years a go I wouldn't have even considered it... but now (after having read Setser everyday in parallel to this blog - absolutely).
And it wasn't an issue in 2001 - this is a recent event (or exacerbated recently... a little before & a lot now).
But the the things the bulls have to realize (or should at least consider)... is this 'condition' could be like the Monsoons... maybe tomorrow PBoC doesn't think it needs all those T-Bills & MBS. Then what?
The yield curve won't be negative anymore THATS for sure and I don't think that would be such a good thing either (with the whole curve rocketing up).
Maybe banks will make money again but they would end up being about the only ones...
I'm not a big believer in 'its different this time' on general principals... But when faced with evidence like the FCB reserve growth covered over at Setser's Blog... Its awfully hard to not notice there is a NEW guest in the living room... and he's awfully large and hairy.
But that still doesn't make it easier on the banks... so what do they do? Go after the international 'carry trade' instead? Mix a little currency risk in with the interest rate risk? Regulators oughta love that.
Lot's of articles like these going around about why the inverted yield curve isn't a concern any more. Basically it's due to foreign inflows, not threat of recession.
And I think they are absolutely right... foreign inflows ARE affecting our credit markets and shifting the yield curve especially on the long end.
And this is fairly new - it didn't used to happen a lot before the 1997 Crisis.
And there is good evidence for this 'it is different this time' scenario too - read Setser's Blog on the huge increase in FCB reserves worlldwide... most held in dollar denominated debt instruments. Getting harder and harder to ignore the new guest in the room... a big hairy guest.
How much is the long end pushed down as a result? Who knows - I remember reading somewhere (after one of AG's testimony before Congress maybe)... something like a pt and a half.
That would put the banks at quite a handicap if they are limited in their geography as to where they can get the 'low end' on the carry - eh?
So what's next, let the banks go direct to China to get their carry? After all we're getting everything else over there.
And nothing like letting them add currency risk to interest rate risk. After all, what's a little more risk in an ocean of it?
CR - Sorry for the sorta double post - Halo appeared to eat the first one & then flipped me a 404... it didn't show up when I reloaded so I recomposed & resent.
That is happening a lot lately. Halo got 'bugs'?
The same bug bit has bit me in the past.
RE: Haloscan, just be careful with the reload button.
Found this the other day:
Understanding FNM debt structures
check out the language options for downloading. Gee, I wonder who their customers are?
check out the language options for downloading. Gee, I wonder who their customers are?
Says it all doesn't it?
Mike in FL,
Your blog doesnt have a e-mail link so this is the best way to contact you. I was wondering if it would be ok for me to use some of the graphs for your blog in my strategy report (properly footnoted of course). I would be happy to send you a copy if you are interested. E-mail me at dvandijk@zacks.com,
Thanks,
Dirk
And I think they are absolutely right... foreign inflows ARE affecting our credit markets and shifting the yield curve especially on the long end.
Well, anybody making the case that inflows are responsible for the inverted yield curve have to explain why the yield curve wasn't inverted prior to mid 2006.
In re: bank profits, all the derivatives in the world don't erase the fundamental economic truth of banking: borrow short, lend long. In a flat-yield-curve environment, that eventually starts to bite.
Well, anybody making the case that inflows are responsible for the inverted yield curve have to explain why the yield curve wasn't inverted prior to mid 2006.
It wasn't inverted until mid-2006, but it certainly was acting atypical long before that. I believe the first signs of inversion were last January (the 2-yr and 10-yr if I recall). And it was flat long before that.
The 10-yr has been remarkably stable since the Fed started tightening (remember 'conundrum'). It finally inverted mid-2006 because the Fed pushed the short-term rates high enough.
Steve's got it right... the 'conundrum'. It wasn't inverted because both ends of the curve way 'low'... Fed started bumping the short end & the PBoC, BoJ & others said 'no thank you very much'.
And all during that time reserve growth has accelerated - throw the Gulf States & Russia & Brazil in with the Asians.
The question isn't did they have an effect... it is more how much & how long. The last one being the most important.
Steve's got it right... the 'conundrum'. It wasn't inverted because both ends of the curve way 'low'... Fed started bumping the short end & the PBoC, BoJ & others said 'no thank you very much'.
I still don't grasp why foreign inflows would distort the shape of the yield curve. Traditionally, longer dated debt pays more because of increased interest rate risk. Why would foreign inflows change that?
Today I see a 2-year note yields 4.94% while a 10-year note yields 4.80%. Why would anyone accept a lower yield from a riskier security? And why is this perverse prediliction somehow peculiar to foreigners?
It seems to me it can't be a supply problem (otherwise the yield on the 2-year would go down).
I certainly can see how foreign inflows would push down yields in general... but why long rates specifically?
ac - You have to look at it from their point of view. The US 10 year bond yields 4.8% - more than the 10 year Euro at 3.5% and also the 10 year Japan at 1.7%.
You are a Japanese or European central bank or an insurance company and you have long term obligations, what is your choice considering the US Fed is near the end of interest rate increases, the Euro Fed is in the middle and the Japanese Fed has barely begun.
Furthermore, they anticipate that when the US Fed is finished hiking short rates, the US economy will slow and the 10 year US bond will appreciate - a capital gain in addition to the highest yield available.
Many investors have a duration preference. However, many also look to maximize their return by shifting along the duration line. So an influx of long duration investors should be offset by others who are more opportunistic. The yield curve should retain its slope.
Why accept a lower rate for a longer duration? Because you expect rates to decline and want to lock in before it happens. Or you are an opportunistic investor looking for the capital gain as described by Tennis_8 above.
The Yield curve is inverted because the short end is artificially high due to market intervention (manipulation) by the Fed. High short term rates choke the economy and cool inflation. A strong yield curve inversion indicates an unfavorable environment for business borrowing, and leads to recession.
I still don't grasp why foreign inflows would distort the shape of the yield curve. Traditionally, longer dated debt pays more because of increased interest rate risk. Why would foreign inflows change that?
Even MORE important than return is getting the damn money placed in USD and not having to deal with it again for a while.
China runs something like a $20-30B surplus every month... according to Setser something like 80% or more goes into USD denominated 'something'... mostly debt but probably some equity too.
The LAST thing they want to do is have the damn things mature soon & have to reposition them... but they also want a liquid maturity if they do have to sell... so they want to buy the longest yet most common (liquid) maturities out there - the 10 year and some 5 year. And MBS.
They buy so damned many of them they drive the price up & the yield down!
And they could careless about minor reserve losses (say 5-10%) resulting from this distortion as long as their objective of currency stabilization (pegged RMB to USD) is met so they can continue to grow their export market.
Minor reserve losses are just the price of 'doing business'. If the RMB skies - they'll have way bigger problems than a few billion in lost reserves... they might end up with a revolution.
The problem we all make is we think like 'us'... not like 'them'. Put your head in their problems & you see why they do what they do.
However - it is getting so out of balance that the losses could mount to a level above their acceptable pain threashold... that is what happened to the Japanese leading up to Plaza... but the effects after Plaza weren't so much fun either... and they didn't have 100s of millions of hungry peasants looking for a better life.
Interesting hardly describes it - it will be the story that defines this whole century.
Thank-you, Mike_in_Fl, for posting the link to your excellent chart "Foreclosures keep on climbing".
I've been trying for days to drive-home an important point about the recency-bias that's so prevalent here and how it can lead to spectacularly-wrong conclusions, but you made my case with a single chart.
Sebastia