The Yield Curve Neither Hires nor Borrows
A great verbal war seems to be underway among financial and economic pundits. One pundits' model says "RECESSION" while another says "NO RECESSION." I read one such battle this weekend. It was over what the current message of the yield curve was. Both arguments were passionate and seem to be well articulated and seemingly supported by the data and graphs they provide for the reader. The first research analyst thought that the yield curve slope should be adjusted by his fancy math because of the efforts of the Fed to manage the yield curve via their QE and "operation twist" experiments. His adjusted curve showed the curve is now inverted and signaling an oncoming recession. The second analyst basically argued this academic was nuts and that the curve will invert, on its own, when we are REALLY headed for a recession, no adjustments are necessary. He pointed out that a yield curve inversion has led every recession and the curve is currently steep. The positively sloped yield curve is a sign of good ecoomic activity with moderate inflation expectations. I got tired of the back-and-forth relentless arguing of positions and moved on to a different article.
The next piece I read intrigued me. It was on small business sentiment. I instantly thought back to the bicker-fest I had just read and said to myself "wow, thes guys are missing the big picture here, the yield curve doesn't hire people or borrow money from banks, businesses do!" Small businesses are also responsible for the majority of new jobs created in this country so we really should be focused on what they are telling us, not what the yield curve MIGHT be telling us.
The piece covered research done by a firm called Rcube over in Europe. They have done some really interesting research on small business sentiment surveys, and how you can use that data to create a picture of the future of small business profitability based on the current operating and regulatory environment. They used data from the National Federation of Independant Business (NFIB) to create what they refer to as the "Small Business Profits Indicator". This indicator is a great leading indicator of not only profitability but capital expenditures, employment and earnings. Here is the proof in charts:
Now, while going through all of this, I kept telling myself that the chart of this small business indicator looked so familiar. It bothered me to the point of recreating the research for myself and this way, I could start trying to figure out what I was missing, what was bothering me so much. Then VOILA!! I found it. The graphic picture of this profitability indicator reminded me of the yield curve spread I had seen in the bicker-fest article I had just read. So, I overlayed the two and here is what I got:
The realtionship is stunning. But somthing changed in the relationship and they have parted ways recently. The two data sets had a strong correlation of .68 up until the Fed embarked on its QE mission. Since then, the correlation has plumetted to just .04. This solved for me why this battle of opinions has grown so loud. The yield curve may not be inverted, but business is already operating like it is inverted! The Fed's control of the yield curve may be hiding the reality of what is really going on. Small businesses are telling us that things are not all that hot. They are telling us that they expect profitability to tumble and because of that, we should expect less earnings and thus, less capital spending and thus, less hiring in the future. This means ultimately that if the Fed chooses to raise rates again this year, it will be a big mistake. The message for us in all of this is that we need to listen to those who hire and borrow.
05/24/2016 07:49:24 AM
Now I get it!
Janet Yellen gave a speech on March 29th to the Economic Club of New York and both financial pundits and economists were suprised, even shocked, at Janet Yellen's very dovish tone on the future path of monetary policy here in the US. Heck, it was just 3 months ago when the Fed decided the economy was not only healthy enough to raise interest rates for the first time in years, but to forecast as many as 4 more rate hikes during 2016. So what happened between then and now? Data revisons!
The Industrial Production data series is put out by the Board of Governors of the Federal Reserve System. So, it only makes sence that Janet Yellen was privy to what turned out to be the alarming data revisons (negative revisions) that were going to be released just days after her speech. Here is a graph that shows the data series before and after revisions:
Here is the same data but this is looking at the year-over-year (YOY%) percentage change:
As you can see, the recent data is significantly worse than originally estimated. We have known for months now that the manufacturing sector has been contracting but according to the rivisions, it started contracting 5 months earlier than thought and the contraction is deeper than originally thought. The problems for Janet Yellen don't stop there either.
More data out this week has drastically reduced the real-time Q1 2016 GDP estimate from the Federal Reserve Bank of Atlanta. As you can see below, heading into the new year, estimates were running almost double the Q4 GDP growth rate of just 1.39%. But since peaking in February, through today, the estimate is now barely positive, coming in at just .40%.
There you have it. It is now
clear why Janet Yellen was so cautious in her speech. I expect a slight recovery in Q2 data but I was never in the 4 rate hike camp. I did expect 2 rate hikes in total but it is getting harder and harder to justify any further tightening from the Fed this year.
04/05/2016 12:03:49 PM
The Fed Dilemma: One Major Tool, Two Diverging Economies
The US economy has a problem, which means the Fed has a problem, which means bankers have a problem. It is now undeniable that the manufacturing sector is contracting (in a recession). This is visible in the chart below depicting the YOY% change in industrial production.
However, at this point, the sectors responsible for the production slump are mainly tied to the oil patch. The slump is not wide-spread enough to impact the entire US economy. The manufacturing sector today is roughly 12% of the US economy while the service sector makes up roughly 80%. This means a good portion of the economy is still healthy and growing. A good visual of this is the ISM data for the two sectors. The graph below depicts the two separate series and the two series combined into one, weighted by their economic impact.
Based on this fact alone, It is hard to conclude that the entire US economy is in a recession. However, the sharp drop in the combined index above is worrisome and must be watched closely for signs of contraction. Confirming the split in economic performance, my short-term market-based economic model is recessionary while most of my monthly models and longer leading models remain positive. Trend pressure remains decisively negative so this short-term trend could begin to eventually bleed into the monthly models. I think the market-based model serves as a warning to the Fed that the rate hike cycle must end or it will eventually lead to a US recession down the line.
This poses a challenge for bankers as it relates to managing interest rate risk: which direction, rates up or rates down, is the interest rate risk? The Fed has the data to justify more rate hikes given that wage pressures are rising and we are at "full employment". The
Fed could also just as easily heed the markets warnings and stop hiking rates in order to avoid a US recession in the future. If the Fed does stop now, with the Fed Funds Rate still near zero
the US slides into a recession, this could bring on the specture of NIRP
(negative interest rates)
as a policy tool to the US. The Fed will find itself with limited productive policy tools to fight off a recession therefor we must watch these developments closely. Even though NIRP is an extreme outlier risk at this point in the US, it is prudent for your ALCO to at least discuss it. This should prompt you to develope a contingency plan to be able to earn money under a NIRP scenario. The good news in all of this is that the banking cycle tends to run approximately 4 quarters behind the business cycle so loan demand should continue for a while yet. Thus, for bankers everywhere, the current bout of economic weakness serves a strong credit warning on any future underwriting.
03/07/2016 02:16:51 PM