"Kee" Points with Jim Kee, Ph.D.

Clarity: US stock market indices (S&P 500) hit an all time high today, largely due to events over the past several days that have brought some clarity to markets. In the US, Friday’s payroll report indicated that employment increased by 287,000 jobs in June, a huge improvement over May’s basically flat (11,000 revised) number and well ahead of the 180,000-190,000 number expected by analysts. In Japan, Prime Minister Abe’s Liberal Democratic Party gained in Japan’s “Upper House” elections on Sunday (WSJ), which may increase the odds of the “3rd arrow” of structural reform (including tax, regulatory, and corporate governance reform as well as labor market reform) being implemented. Japanese companies have the lowest return on investment (ROI) in the world and have for 25 years (WSJ, Credit-Suisse, Mckinsey & Co), which has had little to do with central bank policies or government spending policies there (Abe’s first two “arrows”). Finally, it appears that U.K. Home Secretary Theresa May will become Britain’s prime minister because her chief rival, Andrea Leadsom, pulled out (WSJ). May will succeed David Cameron, and while she was opposed to Britain’s EU exit she has stated that there would be no attempts to keep the UK in the EU under her leadership (WSJ). Remarkably, the FTSE 100, or Financial Times Stock Exchange Index of the 100 largest (predominantly) UK companies, is positive for the year.


All of this is occurring amidst a backdrop of historically low interest rates around the world. With money continuing to pile into debt instruments, driving up their prices and lowering their yields, many view this as a recession (US or global) signal. Specifically, it is causing a flattening of yield curves around the world. That means longer-term interest rates are almost as low as short-term interest rates. Normally, interest rates for money to be repaid further out in the future are higher because there is more risk; for example, if I loan you money to be repaid 10 years from now, there is a lot more uncertainty than if I loan you money to be repaid tomorrow. But when long-term interest rates are lower than short-term interest rates, the “yield curve,” which is basically just a plot of interest rates from short-term (e.g. 3 months) to longer-term (e.g. 10 years+), is said to be “inverted.” Since recessions have tended to be preceded by inverted yield curves, most analysts view yield curves that are inverted or close to inverting as a recession signal. This is partly because long-term rates reflect future expected short-term rates, which are a function of growth (among other things), so declining long-term rates can reflect an expected future growth slow-down. As an aside, analysts aren’t always clear about what they are referring to by the yield curve. Some look at the 10-year Treasury yield relative to the 3-month T-bill yield (most commonly). Others look at 10 to 30 year Treasury yields relative to 2-year yields.


However, even though recessions tend to be preceded by inverted yield curves, inverted yield curves aren’t always followed by recessions. Economists often refer to a “bullish flattening” or a “bearish flattening,” meaning that the information potentially derived from a flattening or inverting yield curve depends upon what’s driving it. I once worked for a macroeconomic forecasting firm whoses forecasting model was built upon the premise (research based) that all of the forecasting power of the yield curve was contained in the short-end: if short-term rates (3-month T-bills or the federal funds rate) rise, their model predicted the economy to turn down in 12 months or so, regardless of what long rates are doing. When in 1998 the yield curve inverted, largely because long rates came down (not short rates rising), we had a contrarian “no-recession” call at the time that turned out to be correct. That kind of live, real-time experience (and pressure!) made an impact on this economist, so while inverted yield curves make me nervous, they do not make me as nervous as rising (we’re talking about several hundred basis points) short-term rates. That’s not what we’re seeing today, and the various nowcasting models (Atlanta/New York fed) are registering US economic growth in the 2%+ range - best of the developed world.


And why are long-term rates so low? Part of it, as I have mentioned before, is the declining ratio of capital spending and R&D spending (the contemporary form of capital spending) to cash generation or GDP that has been occurring since 2000. This has led to a “global liquidity glut,” or a lot of money searching for yield and going into fixed-income instruments. Aging global demographics, particularly in emerging market countries where safety net programs are scarce and savings are high, is another reason. A general demand for “safe-haven” assets following the near collapse of the global financial system in 2008 is another. These constitute an increase in the supply of loanable funds. On the demand side, slower global growth following the dramatic reversal of the Chinese-led global boom has lessened the demand for loanable funds (putting downward pressure on rates), as has lower public (government) spending on infrastructure. With very low inflation expectations, these forces on both the supply and the demand for loanable funds likely explain low rates. What makes them anomalously low or negative, in my opinion, is the addition of central bank purchases or quantitative easing programs, particularly now in Europe and Japan. That not only keeps their rates low, but also puts downward pressure on US rates, as any incremental yield on US assets above the rest of the world provides an arbitrage opportunity (arbitrage defined as the opportunity for a riskless gain).