Bears and curves
Aug. 27th, 2005 05:08 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
peterbirksSome time ago I wrote about the mysterious goings-on in the equity markets, with the rapid rise in equity levels since May defying logical explanation in the face of rising commodity prices, poor profits expectations and rising interest rates. I presumed that there was some kind of short squeeze of the small players taking place, although the reasons might have been less complex -- perhaps certain institutional investors were increasing their equity weighting because they felt that they had to put their money somewhere, that gilts looked a horrible bet, and they felt inflation was a threat (see recent performance of gold as a support for this hypothesis). This would indicate a much longer timeframe on the part of the investors than I usually allow for -- say, 10 years, rather than the normal maximum of 18 months. Such long-termism is commendable, even if it is happening for the wrong reasons.
I mention the 10-year timeframe because we currently have an even more recession-indicative situation (although I will return to this point later). The US yield curve has flattened to such a degree that 10-year treasuries now pay 12 basis points more than 2-year treasuries. Now if you are talking to an individual investor, I reckon it would be fairly hard to try to persuade him to tie up his money for 10 years rather than two for an extra 0.12%. But institutional investors are not like you or me. They want to match liabilities to investments. And pension funds in particular like long-distance certainty.
But a 0.12% spread, while not actually an inverted yield curve, is still fairly pathetic, particularly since only a year ago the spread was 1.8%. That seems massive now, but in the grand scheme of things, an extra 1.8% for an extra 8 years of money tied up is nothing to write home about.
Of course, you might say that the money is not tied up. You can trade these products in a very liquid market, and if you had made a swaps trade for 10-years over 2-years a year ago, then you would be sitting on a nice profit today.
But the fundamental nature of the product remains the same. One is a 10-year product and the other is a 2-year product. One has far more certainty attached to it (what will happen in the next two years) than the other (what will happen in the next 10 years). To accept an extra 0.12% for 8 years of uincertainty implies either that you are very certain nothing untoward is going to happen in those 8 years, or that the general appetite for risk is so great that people are prepared to accept a very low price for taking on that risk.
Why is the flattening curve an indicator of a possible recession? Ahh, I'm afraid that you have got me on that one. I think that it's related to a pessimism about the two-year horizon, rather than optimism about the 10-year horizon. But this kind of indicator (most associated with the inverted curve) would imply an expected low appetite for risk over 10 years and and even lower appetite over two years. What we have today is a high appetite for risk over two years and a ridiculously high appetite for risk over 10.
It will end in tears, I tell you.
I mention the 10-year timeframe because we currently have an even more recession-indicative situation (although I will return to this point later). The US yield curve has flattened to such a degree that 10-year treasuries now pay 12 basis points more than 2-year treasuries. Now if you are talking to an individual investor, I reckon it would be fairly hard to try to persuade him to tie up his money for 10 years rather than two for an extra 0.12%. But institutional investors are not like you or me. They want to match liabilities to investments. And pension funds in particular like long-distance certainty.
But a 0.12% spread, while not actually an inverted yield curve, is still fairly pathetic, particularly since only a year ago the spread was 1.8%. That seems massive now, but in the grand scheme of things, an extra 1.8% for an extra 8 years of money tied up is nothing to write home about.
Of course, you might say that the money is not tied up. You can trade these products in a very liquid market, and if you had made a swaps trade for 10-years over 2-years a year ago, then you would be sitting on a nice profit today.
But the fundamental nature of the product remains the same. One is a 10-year product and the other is a 2-year product. One has far more certainty attached to it (what will happen in the next two years) than the other (what will happen in the next 10 years). To accept an extra 0.12% for 8 years of uincertainty implies either that you are very certain nothing untoward is going to happen in those 8 years, or that the general appetite for risk is so great that people are prepared to accept a very low price for taking on that risk.
Why is the flattening curve an indicator of a possible recession? Ahh, I'm afraid that you have got me on that one. I think that it's related to a pessimism about the two-year horizon, rather than optimism about the 10-year horizon. But this kind of indicator (most associated with the inverted curve) would imply an expected low appetite for risk over 10 years and and even lower appetite over two years. What we have today is a high appetite for risk over two years and a ridiculously high appetite for risk over 10.
It will end in tears, I tell you.
no subject
Date: 2005-08-28 04:05 am (UTC)I fear you are right about recession probabilities. The FED in the states here just issued a debt warning regarding consumer debt. But this problem has been a long time in building and it is their fault because they have either done nothing or not sought the power to regulate it if they don't have that power now. I am talking about the massive credit card debt, which is a huge unregulated money supply and should have its own "M". Were the FED to regulate card issuers so that they couldn't keep giving cards to customers who already own several and by their annual wages often shouldn't have gotten the first one, then that would go a long way in solving the problem. Also, they could cap the interest rates which allow the banks to makeup from the customers who fall behind in an ever worsening spiral. No doubt the politicos just lack the guts to tell constituents that they really don't have a constitutional right to take on as much debt as possible. This situation, together with a projected drop in housing prices could really be the drivers for a recession.
BluffTHIS!