Thursday, January 05, 2006

Better than the yield curve?

A yield curve inversion has often been an indicator of recession. However, talk is abundant that "this time it's different" -- long yields are low because of foreign central bank buying, not because the market is predicting recession.

Bill Gross of PIMCO touts a better indicator than the yield curve. He compares time-averaged (say, 5 year duration) rates to short term rates, in contrast with the instantaneous values plotted on the yield curve. It appears this indicator has been more reliable in the past, and is currently predicting an economic slowdown and a bull market for bonds.

This 5-year swap concept is important because the U.S. economy operates in much the same way. With close to a 5-year average life, the entire U.S. bond market can be compared to a 5-year fixed swap. That means that companies, homeowners, and consumers that have borrowed money in recent years – (and purchased assets such as a home that are akin in my example to a 5-year swap) – are now being squeezed in a flat yield curve environment. Visualize a real life example in which you have “financed” a home with an adjustable rate mortgage (in my example you finance a 5-year swap with floating 3-month Libor). As the cost of the ARM increases with higher short rates, your excess income available to spend on discretionary items begins to shrink. If that ARM rate goes too high, you hunker down even more by not eating out, going to movies, or taking a vacation to exotic destinations. The economy in other words slows down. How does this translate into a bond market timing tool? Chart I shows but one of a series of graphs PIMCO uses to indicate when enough is enough – the point at which adjustable short rates rise sufficiently to make the owner of a home or a 5-year swap, or more importantly the economy, cry “no más!” That point comes in this example when Fed Funds rise to meet the average cost of intermediate Treasury financing issued over the past 5 years and the spread between the two disappears.

For sophisticates, please note that this is not the same thing as a flat yield curve. A flat yield curve is a concept comparing current short rates to current 5- and 10-year rates. What my chart does is to compare current short rates to the Treasury’s average intermediate term “coupon,” a more reliable and indicative indicator of economic pain or restrictiveness since it uses an average embedded cost of debt concept instead of a current cost. The standard flatness as measured by current market rates in early 1995 (not shown here) never led to a recession, only a slowdown, just as Chart I would have indicated. In other words, this indicator called for a mild slowdown in 1995which is what we got. The standard flat curve theory called for something more extreme which is something we never got. The embedded cost of debt indicator, therefore, shown in Chart I, has been more reliable.

...yields have peaked in the bond market and will soon peak in Fed Funds producing an economic slow-down in 2006. If the Fed goes beyond 41⁄2% and inverts the yield curve, the possibility of recession will increase. Observant readers will have already noted that the current data point in Chart I is not only calling for an end to the bear bond market, but a recession at some point 12-18 months hence. Perhaps. Much will depend on the future condition of the U.S. housing market and of course global economies – primarily of the Asian variety.


Anonymous said...

Is there a link you can provide to the article that contains that figure?

Anonymous said...

Okay... with a little searching I found it:

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