Curve Flattening and Monetary Policy Effectiveness: Is It Different This Time?


No doubt you’ve read something about the flattening of the yield curve. You may have even heard it inverted. I can always tell when an arcane financial concepts hit the mainstream by when my relatives ask me about it.  I’ve gotten that one a few times lately. 


But let's take that question at face value. Let’s put aside curve inversion for a moment.  What does a *flattening* yield curve mean for monetary policy and the economy? 


Mohamed got me thinking about that question this afternoon: 




The biggest story in financial markets over the past year is not the inversion of the US yield curve, but the bull flattening of the bund curve: here is a chart of Germany 5y/30y slope vs. assets on the ECB balance sheet:  


The end of the ECB’s asset purchase program coincided quite closely with a slowdown in global growth that resulted in the bull flattening of the 5y/30y bund curve. What does that mean? Slowing growth--but also little optimism for a pickup in growth or inflation in the future. Combine that with the factors Mohamed mentioned and you have the recipe for a very big bull flattening. 


Fast forward to the next ECB meeting. How should monetary policy react? Traditionally, as growth slows monetary policy eases, either through rate cuts, or more recently, asset purchases. You can see that clearly in the chart above in 2015 and heck, right through to 2017. 


The flattening in 2014 and again in 2016 both reversed out quite nicely--the first time the result of increased QE from the ECB, and the second time after global growth recovered from the nadir of China growth fears and low oil prices in early 2016. 


Where does that leave the ECB today? In a heap of trouble. They need to steepen the curve. 


Among the myriad problems in Europe are their banks. The flat curves, low growth, and regulatory constraints have strangled big European banks. Look at this chart of return on equity in European banks vs. US banks: 
Sources: Bloomberg, Federal Reserve Bank of St. Louis (FRED)

A flat curve means that banks can’t borrow low (from depositors) and lend high (to borrowers). They have to rely on credit spreads or simply do nothing at all and make money off fees. When banks can’t make money on lending, credit growth suffers. A similar chart of US vs. European credit growth would show a similar dissonance between the US and Europe. 


The ECB must find a way to steepen yield curves. How can they do it? Easing monetary policy *must* be a signal for higher growth and inflation, otherwise it is ineffective and most likely counterproductive. If the ECB believes further easing won’t steepen yield curves, they should say so explicitly and tell the government this is their problem now. 


That would lead to an easing of fiscal policy--via issuing more long end bonds. That would give  Mohamed the supply he so desperately wants for his friends at Allianz. 


Now, let's contrast the situation in Europe with what we see in the US: 






By way of example, look what happened back in 2007: when the Fed started cutting rates, the 5/30y UST spread started to steepen--as one would expect if monetary stimulus coinciding with the end of the business cycle leads to higher growth in the future (the vertical line coincides with the first cut from the Fed). 


Throughout 2008, the curve stayed steep...going over 200bps in mid 2009. The first round of QE 
Steepened the curve even more: 5y/30y spread topped out at over 250bps in 2010. 


That was very supportive for credit growth--which is one of monetary policy’s core transmission mechanisms. 


Now, looking at the situation today: here is the same chart, 5y/30y ust spread and the fed funds rate.

This time, the curve FLATTENED when the Fed started cutting rates. 


The market is telling the fed and the ECB that they don’t believe the traditional monetary policy transmission mechanisms work anymore. 


Do you believe the market has that right? The market opportunity is clear---bet on further flattening and stagnation if monetary policy is broken--bet on steepening if you think a combination of normal business cycle re-ignition and Fed and ECB easing can sort this out and  return growth to trend. 


My take: I think the market has gotten way out ahead of itself and is trading on 1) fear and 2) momentum. Real money guys benchmarked to indexes--who happen to be getting eaten alive by passive indexation--caught on to the rally in the front end, but have reacted by buying long end duration and convexity. They are going to stay long until proven otherwise. Nobody wants to be left behind in the great bond rally of 2019. 

Now, put on your behavioral finance hat. If you have skin in the game, ask yourself or your colleagues these types of questions:
  • What is the probability the US and/or European governments pass fiscal stimulus packages of at least 2%/GDP per annum? 
  • What is the probability that US and European monetary policy will prove ineffective over the next year--as demonstrated by a 5/30y curves in US and Germany flatter 1 year from now vs. where they are today? 
  • How much of this is Soros-esque reflexivity, reflecting the “fear of fear itself” and a self-fulfilling prophecy of lower long-term interest rates? If you buy into that--what evidence can you bring to the table? 
  • Curves have re-steepened in the past--prove to me why this time is different.


These are the type of questions that can get us past rank speculation and productive discussions about what is baked into the markets and how we can exploit that to generate alpha.

skewrisk@gmail.com
@EMinflationista
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Skr
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September 3, 2019 at 7:20 PM ×

Hey Shawn,this is where I was last week when asking what's the question. It might give you a boost...

The way I see it we have three old fashioned variables that are going to come to a head over the next year:

1) People
2) Central Banks
3) Political

Slice or dice it any way you want, it will come down to the reaction of each variable to the other. Every thing else is peripheral.
Same auld, same auld, but maybe just maybe this time is different.

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justabeancounter
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September 4, 2019 at 1:35 AM ×

Been a while since I checked the blog and what timing. Great post mate.

I myself am in 2 minds, one thinks yeah ripe for a steepener but then maybe we're "in a new paradigm" where once the usual mechanisms could be relied upon but now in an ongoing ZIRP world does this still hold true? Are we, in the words of the Vapors, turning Japanese?

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September 4, 2019 at 6:02 AM ×



justabeancounter...

hey , you want start in my Queensland Funds of Funds "Guesser" fund?

My "Guesser" fund will strip fees from your capital that is employed within a another "Guesser" fund.

From which point ...my funds will handed down the lineage to more guessers.

If i learned anything from him...it okay to stay away from guessers...hand it over.

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Gus
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September 4, 2019 at 9:03 PM ×

How significant to steepening would be a resolution of the China vs US trade/tariffs situation, i.e., would that represent a stimulus on par with potential fiscal or monetary stimulus?

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Skr
admin
September 4, 2019 at 10:18 PM ×

Big blow Numbers on Friday? Good news on the trade/tariffs? The Fed backs Trump?, Trump backs the economy? The people back Trump?. Other nations follow suit? That is how you do it.
Easy!

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September 5, 2019 at 4:21 PM ×

chronic pain lasts longer than acute pain and is generally somewhat resistant to medical treatment . It's usually associated with a long-term illness, such as osteoarthritis . In some cases, such as with fibromyalgia, it's one of the defining characteristic of the disease. Chronic pain can be the result of damaged tissue, but very often is attributable to nerve damage.

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September 5, 2019 at 6:25 PM ×

chronic pain lasts longer than acute pain and is generally somewhat resistant to medical treatment . It's usually associated with a long-term illness, such as osteoarthritis . In some cases, such as with fibromyalgia, it's one of the defining characteristic of the disease. Chronic pain can be the result of damaged tissue, but very often is attributable to nerve damage.

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nevnej
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September 5, 2019 at 8:22 PM ×

@gus
your question triggers some thoughts ...
steepening would represent a stimulus, as normally achieved through sufficient lowering of short rates, which is basically what monetary stimulus is (in the pre-NIRP traditional framework). So sufficiently low short rates and steepening and monetary stimulus used to be synonymous, and now we have already low short rates without steepening, and the question is how much monetary stimulus is achieved just from lowering rates versus steepening curve at whatever rates. Achieving steepening without lowering short rates if necessary could still come from fiscal stimulus (sell enough long bonds) or the maybe fed could engineer steepening by selling long bonds.

But even if it may be possible to achieve steepening as a policy tool (and didn't Ben Bernanke say it is always easy to create inflation if desired), it may be important to consider your question in the context of reverse effects: a steepening may not cause as much as also result from and reflect stronger economic growth and both real and nominal growth expectations. The bond market and yield curve is not just a channel to affect the economy, but is a big signal reflecting the state of the economy.

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September 6, 2019 at 7:57 AM ×



@gus...

piss off gus....piss off all you nine power brokers! I'm retired hahaha...

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September 6, 2019 at 12:21 PM ×



someone bring Kerry back. someone tell him that the murdoch's are getting jack shit...and lachan is bigger a fuck up than ever...

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September 6, 2019 at 1:29 PM ×



amps has had few tonight. but bear with me lads. i think it's only right that since i've been given enough rope here to hang myself...that i might as well push the envelope. give'em a chance.

hey , sir...lord...whaddya think of Kerry's magic touch?

ya think Kerry would love to be here today and run with amps?

ya reckon?

ya reckon Kerry was spot on to leave a little ol' bookworm a gift.

or do reckon ...being from your club...that Kerry gave away too much to just about anyone?

i know whaddya would've done with those broodmares.

anyway , it's all academic now. you lot never knew...and will never never know...i will make sure it.








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September 6, 2019 at 4:30 PM ×




where can amps buy his "rat pack" hollywood hat?

who's in the rat pack in hollywood?

that's right ...the world's most frustrated gangsters.





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September 8, 2019 at 2:22 AM ×



its sunday morning here...amps has finally found the perfect setup.

lets send amps to america.

why not put amps with miley cyrus?

come one...why not...

amps is a pro at being made a spectacle of to make others money...

while miley is pro at making a spectacle of herself to make money...

it's the perfect american capitalist dream!

called it the american dream team.

yeah la la la land really suits amps...yeah

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September 8, 2019 at 3:06 AM ×



it's all rigged. from trump tower...to notting hill...from canberra...to hollywood...from wall street...to aspers...from the palace...to south sydney...it all rigged.

the only way you can be truly independent...is to do a gates/jobs/zuckerberg...build your own shit in the garage...and tell people good luck...

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Moniker
admin
September 12, 2019 at 1:35 PM ×

To whom it may concern: Europe is well and truly cooked. Draghi just closed the Brexit case. Doubling down on my EURUSD parity.

And....here's a bolder prediction: Germany will leave the Euro within 3 years. If they don't do it under a reasonable centre-right/centre-left govt, a far harder right-wing government will do it in a much messier fashion. Why?

France is the lynchpin and is considerably more ill than most of the world realizes. It's always the quiet ones that kill you. When the bill comes due for France, there isn't enough money in the world to fix it....

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Anonymous
admin
September 12, 2019 at 8:19 PM ×

France’s recent structural reforms under Macron have lit a fire there to the upside. The EZ has a wonderful combination of lowest unemployment in years, super stimulative monetary policy, a cleaned up banking system (with only a few small exceptions in Italy), and fiscal firepower in aggregate. The weakness in German manufacturing is triggering fiscal and monetary stimulus in the face of a very strong domestic backdrop across Europe. EZ reflation trades are screaming buys here

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September 15, 2019 at 11:50 PM ×




its monday morning here...and amps has finished reading the weekend papers.

his find it quite amusing that the players down south are disputing the rights to future pay tv sports channel 12.

his would like to inform y'all that packer & gongstors & ((co)) real estate holdings and cash are nothing but american options on the rights to the channel. that's all they are...american options.

they have been worthless since the day Kerry left us...there just pieces of paper with an option to exercise the use of the channel at any given time shall the channel be free & available for use...that is all.

the holders of these american options have waited opportunistically for their chance to cash in on an option of great utility that was originated way before they knew anything about it.

Kerry left behind a bunch of opportunists...that think they own the option rights that he left behind...

stop your bitching down in sydney and get a life...

Hat Tip:

don't take any advice from victoria...

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September 15, 2019 at 11:57 PM ×



all your american & european options in cash & real estate are way out of the money and are worthless. their not coming back into the money. the theta has expired years ago.

unless you can bring Kerry back...

give it up guys.

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HURDY
admin
September 17, 2019 at 4:46 PM ×

"The market is telling the fed and the ECB that they don’t believe the traditional monetary policy transmission mechanisms work anymore.


Do you believe the market has that right?"

Something is broken. The two questions I am asking are:

1. Will retail investors buy negative yielding certificates of deposit? Because if they don't bank NIM will fall apart (as you mention)

2.) Barring the weekends events, was the great bond rally of 2019 a sign of general panic, or panic purchasing, or a locking in of rates in anticipation of continued low interest rates (and possibly negative rate environments?

Pretty basic I know but I can't just move on from these questions.

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dercy lyne
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September 18, 2019 at 8:12 AM ×

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