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’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

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.

Why the Fed Will Not “Taper”

Is the Fed going to “taper”? In other words, will it slow the rate of monetary expansion? When will the Fed do this?

That’s what everyone wants to know. As the central bank for the world’s biggest consumer, the Fed is especially important. Their actions have a major effect on the actions of other central banks. The Bank of Canada’s policy is in many ways a function of the Fed’s.

Canada’s head central banker Poloz will not rock the boat. He fears price deflation. The central bankers in Europe and Britain are explicitly committed to inflation. More and more central banks are joining to cause of money printing, like Japan and Australia, yet the Fed seems to be a bit of a wild card.

That’s because because of Bernanke’s remarks on June 19, where he appeared to raise the Fed’s unemployment target from 6.5% to 7%. He suggested the Fed might slow its bond purchases sooner than previously indicated.

Bernanke went out on a limb and changed the target numbers for unemployment in his speech from what was written in the FOMC report.

St. Louis Fed President James Bullard was critical of Bernanke’s comments, in a wishy-washy bureaucratic sort of way. He tried to tell us that Bernanke didn’t really mean what he said. Bernanke even later came out and confirmed his position is the same as it’s always been: “When the economy gets better, we’ll stop. Someday. Maybe.”

Which sort of goes without saying. Of course the Fed plans to execute its promised “exit plan” when the economy gets better. That’s the whole idea behind extraordinary measures like quadrupling its monetary base since the 2008 crisis with QE 1-3. So what’s the big deal?

Other than Bernanke’s 7% comment, the FOMC has been very clear about what it plans to do. The position in the June 19 press release was unchanged from their March press release. The March release was the same as the January release. Literally the sameword for word.

In these press releases, the FOMC has been explicit. The Federal Reserve will maintain its current policy of QE if the US unemployment rate remains above 6.5% and price inflation remains below 2.5%.

All this debate over whether the Fed will “taper,” and all because no one seems to read what the FOMC says.

A few FOMC members said maybe they should taper later this year. But unemployment is not falling fast enough. Price inflation is not rising fast enough. The Fed’s policy is unlikely to change.

Even if it does change, and they slow the rate of monetary expansion, they will be forced to intervene again. No one mentions that there was tapering after the previous QE’s. Heck, they didn’t just taper in 2012: they actually deflated slightly.

But these little taper episodes don’t last. They simply led to further expansion later. So why not a little bit of tapering after QE3? But that will eventually necessitate QE4. When central banks begin slowing their monetary expansion, the correction will manifest and they will intervene again in desperation.

Despite this reality, economists, investors, and financial reporters are obsessed with rumors and hypotheticals because they do not understand central bank policy.

The spastic reaction of investors was very interesting. Markets fell. Yields shot up quickly as a massive $80 billion was pulled from bond funds in June. Gold briefly fell below $1200. Clearly this illustrates that this economic error cycle is perpetuated entirely by faith in central bank bureaucrats to keep the money pumping. Which is, by the way, exactly what the Austrian business cycle tells us.

You can quite clearly see how the Fed’s expansion is correlated with stock market performance in the last few years. Any time the markets have been worried, the Bernanke Fed has stepped up to deliver QE.

s&p and fed

I don’t think the Fed is communicating any kind of serious change in policy. And regardless of what they say, they are completely trapped by their own policy.

FRED Graph

The Fed cannot pull off a smooth “Exit Plan” with that monster they call a balance sheet without causing a crash far more vicious than 2008.

Is there any way the Federal Reserve could avoid this?

Actually, yes. Their asset sales would have to be offset by the releasing of commercial banks’ excess reserves into the economy. Currently these reserves are massive, corresponding to the Fed’s expansion.

Graph of Excess Reserves of Depository Institutions (DISCONTINUED SERIES)

If the Fed stopped QE entirely and started selling assets, but the banks lent out their excess reserves, you wouldn’t even notice the Fed’s exit. In fact, there would be price inflation. That’s because the fractional reserve process could generate nearly $10 trillion in new money out of those excess reserves.

But this will never happen. This becomes obvious as soon as you ask: “Why would the big banks want to release their excess reserves?”

They are not lending now, so why would they want to lend it when the Fed is selling assets and therefore bringing about a recession? The banks are hoarding their excess reserves now due to extreme uncertainty and impaired balance sheets. They are less likely to lend those funds if the Fed tapers.

But what if the Fed tapers and stops paying interest on excess reserves? Yes, the could do this if they wanted. This is a relatively new policy implemented in 2008. But halting this would have little effect.

The banks earn almost nothing on their deposits at the Fed: close to zero percent. Going from almost-zero to zero will be insufficient motivation to lend, especially when the economy is expected to slowdown. Better to make zero return than risk losing 5% or 10% or more when the economy goes bad.

But what if Bernanke went further? He could charge the banks fees and penalties for having too high a level of reserves. I do not believe he will do this because the banks would not like it. Due to counter-party risk and the danger of short-term creditors doing a bank run on a major institution, it’s least risky for the banks to hold their reserves at the Fed.

Another reason why he and other central banks will not force their big banks to lend: they fear massive inflation would result, and no one wants to deal with that. Bringing it under control would bring about a crippling depression.

An interesting possibility that should be considered is the Fed reducing the rate of QE3 just before Bernanke departs in Feb 2014. They could then safely blame him for any negative effects which follow. If the Fed announces a reduction in QE in September, that would fit with this scenario. However, I do not believe they will do this. Bernanke wants to ride off into the sunset without any additional controversy. He is not even speaking at the Jackson Hole meeting this summer, due to “personal reasons.” He wants to get out his position stealthily rather than in a flurry of disputation. He doesn’t want to push a tapering policy that will reflect badly on him as he leaves his position.

And what’s true of Bernanke is true of all the central bankers — none of them want to look bad in front of their friends. So they will continue to inflate.

CONCLUSION

After the NASDAQ bubble exploded and the US went into recession, Alan Greenspan pumped money into the economy to generate a new boom cycle. Over that time, the economy responded to the resulting misshapen financial markets with the formation of a housing bubble. Greenspan departed and Bernanke began to raise rates. The result was the 2008 crash, during which Bernanke & Friends carried out an unprecedented expansion of the monetary base. Another boom period was generated. The US stock market is again making all-time highs, optimism is much more widespread, and all forecasts and experts seem to agree that the recovery is robust and genuine. This means we are in the economic danger zone.

The Fed’s 100-year pattern of propagating booms and busts will continue either until they crash the economy by selling assets, or a monetary crisis arises that they cannot control.

The Fed may tinker with its money supply here and there, but we are a long way from any “exit plan.” Until then, don’t count on any real tapering for any significant amount of time.

Carney vs. the British Pound

UK citizens are running out of time before Mark Carney takes over their central bank.

Carney got the Bank of England job because he was a friend of bank bailouts and has shown no reluctance when it comes to printing money.

Mike Amey, head of sterling bonds at PIMCO, believe that’s what Carney plans to do when he takes over the BoE. He predicts Carney will devalue the pound by as much as 15%. That’s because Britain is desperate, and central bankers don’t really have any solutions other than “MOAR PRINTING.”

I’m so glad Carney’s going to be gone, not that I expect Stephen Poloz to be any better. But we should feel bad for the citizens of the UK. The pound has already lost significant value in recent years.

— Read more at The Telegraph —

 

Mark Carney - HERE I COME BRITAIN YOU SHOULD SELL YOUR POUNDS BEFORE I GET THERE

Economic Ignoramus Stephen Poloz to Replace Carney as Bank of Canada Governor

So far, we don’t know much about Mr Poloz on a philosophical level.

Based on the little we do know, I think he is a bad choice. He has a PhD in economics, so he likely knows very little about economics.

We also know he has spent most of his life as a bureaucrat. Most of his career has been “public service” (cough cough) at the BoC and Export Development Canada. I’m sure he made lots of friends in the export industry there. Friends who will really appreciate a subsidy in the form of monetary inflation.

Back in late 2008, he wrote a commentary on the financial crisis. In essence, he appeals to animal spirits, like all Keynesians who are baffled by economic law. He blames it on nothing more than a change in psychology following the 9/11 attacks. Everyone had a “live for the moment” attitude, he says, and ultimately this created the housing bubble.

The first sign of failure in economic analysis is a reliance on nonscientific pop-psychology. He completely fails to identify the source of bubbles and account for why business cycles occur. The culpability of central banks is nowhere challenged. He pleads agnostic about the ability of economists to understand the cause of bubbles at all. He does not understand the Austrian theory of the business cycle.

Based on these facts, I can safely conclude he is an Keynesian/inflationist/mercantilist. Sort of like, well, all central bankers. He may prove to be better or worse than Carney. Only time will tell.

Ultimately, it matters only a little who is the head of the Bank of Canada. The system as such is the problem, and not so much the individual people in charge.

— Read more at BoC’s website — 

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