RED ALERT! Canada’s Yield Curve is Inverting

The yield curve in Canada shows signs of inverting. We need to watch this carefully as it is a strong indicator that we are heading towards a recession.

This week the rate on 3-month Canadian t-bills went higher than all the other rates out to the 5-year bond.

Here’s why this is important:

The yield curve is a graphical representation of the interest rates for debt instruments over different maturity dates. It normally looks something like this:

normal yield

Economic actors prefer present goods to future goods, so future goods can only be exchanged for present goods at a discount. This gives rise to the phenomenon of interest (hence the term “discount rate” in finance when determining the present value of future cash flows).

The normal yield curve shows that the farther out in time you go for the maturity date, the higher the interest rate. There are two basic reasons. First, there is the issue of inflation, and lenders must take into account the depreciation of the monetary unit over time. Because the money supply is always expanding, the purchasing power of money tends to fall over time. Money paid back in the future is worth less with each passing year.

The second reason for the normal yield curve shape is that the default risk increases over time. The risk of default might be quite low over one year. But over ten years? Twenty years? Uncertainty is greater over that time period. The longer the debt takes to mature, the more one is subject to default risk, and so lenders compensate for this by demanding a higher rate of return.

This explains the shape of the normal yield curve.  But there are unusual situations where the yield curve inverts — the short maturity end of the curve has a higher rate than longer-term debt.  This is not normal, for reasons that should be obvious in light of the preceding discussion.

Putting aside the yield on the 1-month t-bill, we can usually assume that if the 3-month t-bill has a higher rate than the 30-year bond, the economy is going into a recession.

This implies a short-term liquidity crunch. Borrowers are starting to panic over their misguided investments due to artificially low short-term rates. They see impending losses. They will pay more for a 90-day loan than for a locked-in 5-year loan.

Meanwhile, the lenders are growing fearful about the short-term state of the economy as well. A recession pushes interest rates lower because the economy is weaker. Lenders are willing to give up the inflation premium they normally require. They nail down today’s higher long-term rates by purchasing more long-term bonds — which raises their price, and pushes down the rate.

Remember, when central banks are expanding the money supply, they buy up short-term t-bills to bid up their prices and push down their yields. The monetary expansion misallocates capital — investors and businessmen put more money into projects than the “real” economy can support, hence the “boom” phase preceding the “bust.” An inverted yield curve — rising short-term rates — signifies a liquidity shortage. Money is desperately needed right now to sustain capital projects.

(A detailed scholarly treatment of this issue can be found here — it’s a Ph.D dissertation, so it’s interesting albeit kind of dull).

So the inversion of the yield curve normally signals a recession. However, the yield curve is not fully inverted. The 3-month bill’s rate is still less than the 10- and 30-year bond rate. But these longer-term rates are plummeting rapidly.

Look at this 10-year yield totally nosediving:

10 year falling

And the 30-year treasury bond is plummeting as well — investors are giving the Canadian government their money for 1.833%, when just four weeks ago it was 2.3%. A year ago it was a solid 100 bps higher. Investors are giving Ottawa their money for less than 2% for 30 years. The world has gone insane.

(Although if it makes you feel better, it’s even more insane over in Europe. I mean seriously, people are lending the government of France — FRANCE! — money for 10-years at 0.5%. What the heck?! But it’s sweet deal when you’re a primary dealer and can just buy total crap like French 10-year bonds and flip it to the ECB.)

Despite the Bank of Canada’s recent surprise rate cut, the Bank of Canada has been significantly slowing the rate of growth of its asset purchases in recent months, as I reported a few weeks ago.

boc jan15

At the same time, down south, the Federal Reserve — the central bank of our biggest trading partner — has ended QE3 and its balance sheet no longer showing any net growth.

fedmbasejan30

I am not clear how the BoC’s recent rate cut will factor into this, nor am I clear what Yellen and the Fed will do if the US economy shows signs of panic (QE4?), but I think the inversion of our yield curve is related to all this. Remember, short-term rates are lowered by periods of central bank monetary expansion because they buy up debt at the short end of the curve with newly created money. All signs have pointed to the end or at least slow down of high monetary inflation by these central banks. Businessmen who thought all this investment in capital was justified because of distorted interest rates are getting a wake-up call. The truth is manifesting in the debt markets.

So watch the yield curve in Canada closely in the near future. If the 3-month rate goes above the 30-year rate, I’d say there is a 90% chance of recession within six months. If the inversion doesn’t go all the way out to the 30-year, then it may not indicate recession but it still suggests slower growth going forward.

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Bank of Canada Has More Assets Than Ever

The Bank of Canada’s balance sheet is now bigger than ever. The central bank grows fat on the debts created by Ottawa.

boc may14

The rate of growth had slowed a bit in recent months, but the latest data tells us that Governor Poloz really doesn’t know what to do other than create new money and buy stuff. This is exasperating the business cycle and driving down the price of the Canadian dollar.

The Bank of Canada’s assets are 99% Canadian government bills and bonds. Buying more of these bids up their prices and pushes interest rates lower than they would be otherwise.

The newly created money enters the capital markets, and begins distorting the market’s allocation of resources. This is the cause of business cycles.

Interestingly, rates are so low in Canada that capital is nearly free, but the Eastern economy is still a mess. According to Keynesianism, the entire country should be on the verge of Utopia.

The aggressive monetary policy was kicked off by Carney, shortly after selling off the Bank’s emergency acquisitions of the financial crisis. Poloz is continuing this policy. He is trying to juice the Canadian economy by driving down the value of the Canadian dollar, thereby increasing exports, as he told us in his April 16 rate decision. This kind of short-sighted and special-interest-serving policy is to be expected from central bankers, particularly ones who worked Export Development Canada for more than a decade, like Poloz.

Hilariously, a few days ago the mainstream media churned out a puff piece about how Poloz is the “king” of central bankers and other central bankers want to be like him. The article presents Poloz as a really cool dude because when he says something, the Canadian dollar’s value is more greatly affected than the value of other currencies when their central bankers talk.

It never seems to occur to anyone that this is a horrible, horrible thing. It shows that the dollar is dangerously sensitive to the whims of central bankers, and that is not healthy for an economy. Uncertainty due to regulatory hazard is destructive to economic opportunity.

But of course, words are one thing, and the biggest impact on the economy emerges from the BoC’s actions — i.e. printing money. And as we can see, the Bank of Canada still going full steam ahead with that plan.

Bank of Canada’s Balance Sheet: Still Trending Higher

The Bank of Canada has somewhat arrested the rate of growth on its balance sheet. The monetary base has reached a bit of a “plateau” for now, very close to all-time highs from December 2013 ($91.045 billion on the books as of April 30 2014).

It seems Poloz is trying to follow along with the general “tapering” strategy of the Fed. In order to maintain the “boom” of this business cycle (as lame a boom as it might be), the balance sheet’s size must continue to trend higher. But the flattening of the curve means that the BoC’s purchases are slowing. This will tend to push down asset prices.

boc april14

Is the Taper a Big Lie?

(NOTE TO READER: There was a considerable time lag between the beginning of the QE3 taper’s declared beginning and when it actually started. This article was written during the lag, suggesting that the taper was all hype and no reality. Since then, the taper did become real and QE3 ended.)

The much-talked-about taper could be nothing more than a big joke. Where is the statistical evidence of the taper?

Let’s look at the last 10 years of the Federal Reserve’s balance sheet.

taper1

Here you can see all three QEs laid out nicely.

Let’s “zoom in” and look at just the last year.

taper2

The rate of growth briefly slowed then picked right back up. Other purchases appear to be offsetting the taper, at least so far. On net, no taper. Watch what they do, don’t fret too much over what they say (central bankers lie all the time).

Meanwhile, despite media reports and promises from European central bankers that they will inflate to prevent recession, the ECB is engaged in a deflationary policy, and has been for nearly a year.

Sometimes the official central bank statistics don’t match their words.

The Fed has been saying it will not let interest rates rise, yet at the same time it will slow its rate of purchasing assets. I don’t know how that is supposed to work, since regardless of the Federal Funds target rate, the market sets the real Federal Funds rate. Yet it almost makes sense if you assume while they might buy less crap via QE3, they will balance that with more purchases of different crap.

Bank of Canada’s Balance Sheet Continues to Swell

The Bank of Canada’s balance sheet shed about a billion dollars in August, but remains at record high levels.

Governor Poloz, like everyone else, is watching the Fed. With no taper in September (as we predicted), he is unlikely to do much to change BoC policy. To keep the Canadian dollar from appreciating too greatly against the US dollar, the BoC must maintain a level of quantitative easing consistent with the Fed’s own. Poloz is a mercantilist, and is therefore opposed to having a strong Canadian currency.

BoC as of October

Fed Discontinues “Excess Reserves” Chart

The St. Louis Federal Reserve Bank will no longer publish the chart showing excess reserves of commercial banks.

I can say little about why this decision was made. I suspect the Fed wants to draw minimal attention to the fact that most QE money goes into excess reserves.

The charts unequivocally show that the increase in excess reserves has corresponded almost exactly to the increase in the Fed’s monetary base. Observe:

MONETARY BASE

FRED Graph

EXCESS RESERVES

Graph of Excess Reserves of Depository Institutions

Why is this important? It shows to what extent the Fed’s different batches of QE are stockpiled by the commercial banks rather than pumped into the economy in the forms of loans.

When the Fed increases its balance sheet, the general rule is that the money will cause the money supply to increase because of fractional reserve banking.

However, after in the 2008 crisis, the M1 Multiplier tanked, meaning that each dollar added to the monetary base added much less to the money supply (M1). 

Graph of M1 Money Multiplier

The Fed has expanded its monetary base dramatically, but the M1 Multiplier makes us wonder where all that money went. The excess reserves chart shows us where most of the QE money goes.

As QE continues, we will have to assume excess reserves are rising if the M1 Multiplier remains extremely low. If the multiplier begins to rise, then more new money is entering the economy, not being added excess reserves. If M1 begins to skyrocket, then that means excess reserves are being loaned out.

— No more excess reserves charts — 

 

 

The Bank of Canada’s Balance Sheet: Bigger than During the Financial Crisis

During the 2008 financial crisis, the Bank of Canada intervened with an unprecedented 50% expansion of its balance sheet to a total of nearly $80 billion. This was done by creating money and purchasing assets from the big banks in order to add liquidity to the market.

By mid-2010, they had unloaded these emergency acquisitions and their balance sheet returned to pre-crisis levels.

But now, after years of growth, the Bank of Canada’s balance sheet is bigger than ever. The BoC holds nearly $90 billion in assets.

boc july 2013

But the crisis is over, isn’t it? The Bank of Canada is trying to keep the Canadian dollar down and interest rates low. They are acting like the crisis is not over, or like another crisis is waiting to emerge.

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