Yield Curve Sloping Towards the "R" Word

In my economic thesis, there lies a scenario where consumption moves higher and higher, because incomes are in the process of moving higher and higher. Then, once consumption has really vamped up and prices move much higher, the Fed steps in and raises interest rates to levels that puts a stop on inflation once and for all. Then there is a recession.

Then there is the bond markets interpretation of what's going to happen. The bond guy's opinion: There's just going to be a recession, and that's final. The discount rate that the Federal Reserve has set is sitting at a nice lofty 5.25%. The 2-year note is sitting at a less than lofty rate of 4.63%. And the 10-year? That's at 4.55%. Pretty darn close to a full basis point lower than the discount rate. Mr. Greenspan's conundrum is confounding the markets more and more every day. The basic fact is, as market votes go, the bond guys are dead certain there's going to be a recession.... and who cares about the mechanics behind it.

Here's a chart on the yield for the 10-year (click on thumbnail to enlarge):

If there were any support anywhere in sight, it would be akin to a 100-year-old rotting wooden outhouse sitting on top of the San Andreas Fault during, oh, say a 9.2 earthquake? Take my word for it, when the big one hits, #@%! is going fly everywhere.

The mechanics of an inverted yield curve: Yield and price are inverses of each other. So, if there is a mad rush into the 10-year, meaning lots of buying (pushing prices higher), then yield falls as is what is happening right now. That would be the inverse relationship. So, why would someone buy so many 10-years vs. the higher yield in the 2-year? Because you can lock in a rate for 10 years right now, whereas in 2 years (or shorter) you, as an investor have no clue where rates are going to be once your note expires, but you're pretty darn sure that with an impending recession, rates will be lower. Why take the risk of rolling your 2-year at 4.63% into perhaps 2% in the future? You don't. So, to attract buyers into the shorter dated yields, you have to offer "above normal" rates. That's the price of the uncertain rewards. And that's why the 10-year is pushing higher and higher in price. That's where the money is flowing.

I'm more concerned with the timing of this dooming event. If personal income is still pushing higher, as it has been, then consumption will follow. Why? Take a look at the savings rate here in the United States. It's somewhere in the negative numbers. So, if income moves higher, consumption follows, because Ken and Barbie can't save a dime to save their lives. I see the dooming event occurring probably closer to the springtime. Consumption still needs to kick up before there is any decline. That's the path that incomes are following.

So, in the meantime, Ken & Barbie can go ahead out back and have a seat on the rickety ol' outhouse seat. They're okay for now. But, eventually, they will want to dig a trench and think about an alternative method of relieving themselves. Cause someday soon, the #@%! is going to hit the fan!

Comments

[huangjin]

I think you're analysis is correct, but have you considered the implication of two things. First, the Fed's job is to fight inflation, and if there is more inflation coming rates are going higher, not lower. Second, if savings are too low a correlary may be that rates are too low. If you look at a historic chart of interest rates, you can see rates have been in a down trend for 24 years. So if we are going to see the savings rate reverse and inflation stopped, it will be with higher rates. One can only hope it's the Asian central banks that have been sucking up the 10 years.