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.


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.


The Central Planning Gambit: Can Central Banks Avoid a Crash?

The Bank for International Settlements put out its annual report on June 29. It says that the recovery is driven primarily by new fiat money generated by central banks. As a result, the pricing of capital assets is badly distorted. The overall theme is Austrian, not Keynesian.

Here is the summary:

A new policy compass is needed to help the global economy step out of the shadow of the Great Financial Crisis. This will involve adjustments to the current policy mix and to policy frameworks with the aim of restoring sustainable and balanced economic growth.

The global economy has shown encouraging signs over the past year but it has not shaken off its post-crisis malaise. Despite an aggressive and broad-based search for yield, with volatility and credit spreads sinking towards historical lows, and unusually accommodative monetary conditions, investment remains weak. Debt, both private and public, continues to rise while productivity growth has extended further its long-term downward trend. There is even talk of secular stagnation. Some banks have rebuilt capital and adjusted their business models, while others have more work to do.

To return to sustainable and balanced growth, policies need to go beyond their traditional focus on the business cycle and take a longer-term perspective — one in which the financial cycle takes centre stage. They need to address head-on the structural deficiencies and resource misallocations masked by strong financial booms and revealed only in the subsequent busts. The only source of lasting prosperity is a stronger supply side. It is essential to move away from debt as the main engine of growth.

Resources have been grossly misallocated by these interventions. Chapter VI begins with the following observations:

Nearly six years after the apex of the financial crisis, the financial sector is still coping with its aftermath. Financial firms find themselves at a crossroads. Shifting attitudes towards risk in the choice of business models will influence the sector’s future profile. The speed of adjustment will be key to the financial sector again becoming a facilitator of economic growth.

The banking sector has made progress in healing its wounds, but balance sheet repair is incomplete. Even though the sector has strengthened its aggregate capital position with retained earnings, progress has not been uniform. Sustainable profitability will thus be critical to completing the job. Accordingly, many banks have adopted more conservative business models promising greater earnings stability and have partly withdrawn from capital market activities.

Looking forward, high indebtedness is the main source of banks’ vulnerability. Banks that have failed to adjust post-crisis face lingering balance sheet weaknesses from direct exposure to overindebted borrowers and the drag of debt overhang on economic recovery (Chapters III and IV). The situation is most acute in Europe, but banks there have stepped up efforts in the past year. Banks in economies less affected by the crisis but at a late financial boom phase must prepare for a slowdown and for dealing with higher non-performing assets.

Then it discusses commercial banks — they are relying on the low interest rate environment to keep submarginal borrowers afloat. This is postponing inevitable losses.

In the United States, non-performing loans tell a different story. After 2009, the country’s banking sector posted steady declines in theaggregate NPL ratio, which fell below 4% at end-2013. Coupled with robust asset growth, this suggests that the sector has madesubstantial progress in putting the crisis behind it. Persistent strains on mortgage borrowers, however, kept the NPL ratios of the two largest government-sponsored enterprises above 7% in 2013.Enforcing balance sheet repair is an important policy challenge in the euro area. The challenge has been complicated by a prolonged period of ultra-low interest rates. To the extent that low rates support wide interest margins, they provide useful respite for poorly performing banks. However, low rates also reduce the cost of – and thus encourage – forbearance, ie keeping effectively insolvent borrowers afloat in order to postpone the recognition of losses. The experience of Japan in the 1990s showed that protracted forbearance not only destabilises the banking sector directly but also acts as a drag on the supply of credit and leads to its misallocation (Chapter III). This underscores the value of the ECB’s asset quality review, which aims to expedite balance sheet repair, thus forming the basis of credible stress tests.

The holy grail of central banking is this: shrink asset bubbles without crashing the economy.

No central bank has ever accomplished this. Yet monetary central planners have big egos — they think they are the smartest people in the entire universe. Right now, they think they have the economy under their control — unemployment slowly falling, economic activity slowly improving, and consumer price inflation is nowhere in sight.

Business cycle “recovery” phases (even weak ones) can’t last forever. The question is, can they pull off their ultimate gambit?

If central banks can unwind the massive increases to their balance sheets without causing recessions, it will show that Keynesian economics works. It will be nothing short of a miracle.

Do you believe in miracles?

US shows two negative indicators

Corporate insiders, apparently bullish no less than a month ago, have been selling nearly seven shares of their company’s stock for each share they are buying. When there is a major rally from summertime lows, you can typically observe the public starting to unload. But insiders seem better than average at buying their own stock on highs and lows. Recently, during the 2012 November lows, they were selling only three shares for every two shares they bought. During the summer lows, the ratio was 2:1.

This rate of selling is high above the long-term average, and close to relatively highs. This suggests that the market is coming up on a correction.

Meanwhile, another report brings grim tidings: The United States’ current account continues to shrink — imports are falling fast.

According to the data, imports are now down two months in a row having fallen 8.4% in the third quarter and 2% in the prior quarter.  This is a rare event and has definitely raises the recessionary “red flag,” according to Robert Brusca, chief economist at FAO Economics. When the economy weakens, imports weaken rather quickly, Brusca notes.

The last time imports declined for two quarters was in 2009, the end of a four-quarter slide in imports during the Great Recession.

Fewer imports is a sign that domestic demand is faltering. A recession is “a real risk,” Brusca said.

Note that the first indicator is probably aggravated due to the fiscal cliff, the second indicator is not.

When the US enters a recession and joins almost every other major economy, Canada will be quick to follow.

What will happen to commodities in 2011?

First, consider the following:

Commodities are up across the board, in some cases quite dramatically. This boom is international — manufacturers are bidding up prices and there are strains on available supplies.

Yet consumer prices are not rising significantly. Canada currently has a higher official inflation rate than the US, but not much more. Commodity prices have been bid up in anticipation of rising consumer demand, a prediction which is not panning out.

Remember the insight of Austrian economics — consumers set final prices, not producers. Consumer spending is weak. Unemployment remains high. Without a surge in consumer spending, these prices are unsustainable. If there is a recession in Asia, and I think there will be (probably next year), then these prices are likely to tank.

Western banks are stockpiling excess reserves. If this money does not get lent out, unemployment will remain high and consumer spending will continue to suffer. There are no signs that bankers will suddenly become optimistic. China is slowing down. Same with South Korea and Japan.

What about gold? Gold follows a different set of rules. Central banks buy and sell gold. It is a hedge against the currency crises and mass inflation, rather than recession, where currency appreciates. China is encouraging its citizens to buy gold. When Austrian business cycle theory bites back at China’s bubble, there may be less drive to build shopping malls where no one buys or sells anything, but people will still yearn to preserve their savings with the precious metal as their government devalues money like its going out of style.

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