Paul Krugman:
One Point Seven Six: The invisible bond vigilantes continue to lure us into their invisible trap. Meanwhile Joe Weisenthal has more about the bizarre response of conservative economists to the failure of interest rates to rise the way they claimed they would: part insistence that somehow the Fed is rigging the market, part denunciations of the markets themselves, because they’re not disciplining government the way they’re supposed to. And as for actually rethinking preconceptions, and considering the possibility that Keynesian economists who told us three years ago that we were in a liquidity trap, and rates would stay low until the economy recovered? Not a chance.
Yield Of Dreams: [I]n unusual and stressful situations, experience — the kind of experience business people gather over years in the market –ceases to be a helpful guide, whereas models and deep historical knowledge have at least a hope of getting at what’s really going on. A case in point would be the remarkably slow realization in the financial industry that the yield curve — the spread between short-term and long-term interest rate, often used as a leading indicator of recessions and recoveries — no longer has its usual meaning. FT Alphaville cites new analysis from Merrill Lynch that starts from the following insight:
We have often heard that the rates market is not priced for a recession yet because the curve remains historically steep. However, this argument ignores the fact that the Fed is at a zero bound. Because the policy rate cannot go negative, plausible paths of the future rate are either flat (Fed on hold) or rising (Fed hikes). As a result, the curve must be structurally steep relative to historical experience when the Fed had room to cut.
Indeed — and the Merrill work, which adjusts the curve using option prices, looks interesting. But what amazes me here is that this is presented as a fresh and surprising insight. Um, if you thought at all in terms of economic models, this was obvious right from the beginning. Here’s me in December 2008, yes, 2008:
The reason for the historical relationship between the slope of the yield curve and the economy’s performance is that the long-term rate is, in effect, a prediction of future short-term rates. If investors expect the economy to contract, they also expect the Fed to cut rates, which tends to make the yield curve negatively sloped. If they expect the economy to expand, they expect the Fed to raise rates, making the yield curve positively sloped. But here’s the thing: the Fed can’t cut rates from here, because they’re already zero. It can, however, raise rates. So the long-term rate has to be above the short-term rate, because under current conditions it’s like an option price: short rates might move up, but they can’t go down. Indeed, if we look at Japan we find that the yield curve was positively sloped all the way through the lost decade.
Just to be clear, I think Merrill’s work here is fine, as was a recent analysis by Lance Roberts making the same point. What I find amazing is simply the fact that it has taken so long — almost three years! — for this to sink in.
