The Yield Curve as a Leading Indicator (October 2005).
By Arturo Estrella, Ph.D. and senior vice president, capital markets department of the research and statistics group, Federal Reserve Bank of New York.
Research primer.
"The difference between long-term and short-term interest rates ('the slope of the yield curve' or 'the term spread') has borne a consistent negative relationship with subsequent real economic activity in the United States, with a lead time of about four to six quarters," writes Estrella in a new piece that reviews the literature since the 1980s on the yield curve and its value as a forecasting tool. The paper also provides context for such questions as:
* Does it matter if the curve changes are driven by the short or the long end?
* Is a yield-curve inversion required for a signal?
* Does the signal have to be persistent??
* What maturity combinations work best?
* Is the evidence robust over time?
With the Treasury yield curve virtually flat at the moment, perhaps poised to invert, Estrella delivers timely insight into what researchers of the past have already uncovered. In short, this paper offers crisp summary of the existing literature that collectively argues that yield curves matter.
Recent Developments in Monetary Macroeconomics and U.S. Dollar Policy (September 2005).
By William T. Gavin, vice president and economist, Federal Reserve Bank of St. Louis.
Working paper.
The Federal Reserve is charged with maintaining the integrity of the dollar, which is widely interpreted with keeping inflation in check. Ideally, a zero inflation rate would be ideal, writes Gavin. He also believes that the same pursuit of absolute price stability is the appropriate policy prescription for managing the world's reserve currency. "The Fed (with the consensus of Congress and the administration)," he writes, "should adopt an explicit numerical objective for the long-run trend in the CPI [the consumer price index]. Personally, I would recommend zero inflation." He goes on to explain:
"To understand why inflation targeting works so well, it is useful to think about
monetary policy as having two uncorrelated, but not independent, instruments. One is the
long-term price objective, and the other is the short-term liquidity position. They are not
independent because, in the long run, the accumulation of reserve growth from setting
short-run liquidity positions (from open market operations) must be consistent with the
long-term price objective. But the two can be uncorrelated in the short run, just as tax
receipts and government spending appear to be uncorrelated over short horizons.
The most important of these instruments is the long-term objective. But it should
almost never change. If policy is appropriate, people will hardly be aware of it as a
policy. The focus will be on the short-run liquidity decisions (short-run changes in the
federal funds target), because setting the federal funds rate target depends on incoming
data and knowledge about the shocks hitting the economy."
Liquidity, Default, Taxes and Yields on Municipal Bonds. (July 2005).
By Junbo Wang, Chunchi Wu (Ph.D. students, Syracuse University), and Frank Zhang (Federal Reserve).
Finance and Economics Discussion Series, Federal Reserve Board.
All things being equal (which is to say all tax effects removed), yields on muni bonds should be comparable to Treasuries of the same maturities. In practice, something less has occurred, observe the authors, who find that muni bond yields "are often higher than expected relative to yields on U.S. Treasury bonds" after correcting for taxes. The yield differential is particularly obvious in longer-maturity bonds, according to the study, which claims to be the first analysis of the trading database recently made available by the Municipal Securities Rulemaking Board. Previous research has argued that the institutions that dominate muni trading are the reason for the less-than-efficient market. But that doesn't fully explain the yield differences, argues the new paper. Default risk also accounts for the muni yield conundrum. Muni defaults? Absolutely. Citing statistics for the 253,850 muni bonds issued between 1977 and 1998, the paper says 1,765 (or roughly 0.7%) defaulted, or about 6.6% of the $375,5 billion of face value of the munis. "Thus the probability of default may not be trivial and is of potentially greater concern for low-rated municipals," the authors advise. Still, that's not enough to fully explain the yield gap. What does? Liquidity risk also accounts for some of the difference. Much of the trading in munis is infrequent. Many issues are traded only a few times, the paper observes, noting that average weekly muni trading is generally less than 12% of Treasury trading. As compensation, investors demand a higher yield for munis relative to a tax-equivalent yield on Treasuries. " Liquidity premium explains about 7 to 13% of the observed municipal yields for AAA bonds, 7 to 16% for AA/A bonds and 8 to 20% for BBB bonds with different maturities," the paper concludes. "Ignoring the liquidity risk effect thus results in an underestimation of municipal bond yields." Overall, "we find that long-term municipal bond yields are higher than the equivalent after-tax Treasury yields largely because both liquidity risk and default risk are higher."
Recent Developments in Monetary Macroeconomics and U.S. Dollar Policy (September 2005).
By William T. Gavin, vice president and economist, Federal Reserve Bank of St. Louis.
Working paper.
The Federal Reserve is charged with maintaining the integrity of the dollar, which is widely interpreted with keeping inflation in check. Ideally, a zero inflation rate would be ideal, writes Gavin. He also believes that the same pursuit of absolute price stability is the appropriate policy prescription for managing the world's reserve currency. "The Fed (with the consensus of Congress and the administration)," he writes, "should adopt an explicit numerical objective for the long-run trend in the CPI [the consumer price index]. Personally, I would recommend zero inflation." He goes on to explain:
"To understand why inflation targeting works so well, it is useful to think about
monetary policy as having two uncorrelated, but not independent, instruments. One is the
long-term price objective, and the other is the short-term liquidity position. They are not
independent because, in the long run, the accumulation of reserve growth from setting
short-run liquidity positions (from open market operations) must be consistent with the
long-term price objective. But the two can be uncorrelated in the short run, just as tax
receipts and government spending appear to be uncorrelated over short horizons.
The most important of these instruments is the long-term objective. But it should
almost never change. If policy is appropriate, people will hardly be aware of it as a
policy. The focus will be on the short-run liquidity decisions (short-run changes in the
federal funds target), because setting the federal funds rate target depends on incoming
data and knowledge about the shocks hitting the economy."
The Effectiveness of Monetary Policy (revised July 2005)
By Robert H. Rasche, senior vice president, St. Louis Fed; and Marcela M. Williams, senior research associate, St. Louis Fed.
Working paper.
Ben Bernanke favors inflation targeting for central banks, as opposed to the relative subjectivity that now prevails with interest-rate-setting policy at America's central bank. Bernanke's view matters because he's said to be a possible successor to Alan Greenspan, whose term as chairman on the board of governors at the Fed expires in January. Bernanke, a former Fed governor who joined the White House staff in July as chairman of the U.S. Council of Economic Advisors, recommends an inflation target of one-to-two percent, measured by the core personal consumption price index, the paper relates. The St. Louis Fed article also finds that: "inflation-targeting central banks appear to have an admirable record of consistently hitting targets on a 'medium-run' horizon. However, it is not clear what the marginal contribution of inflation targeting beyond a credible commitment to price stability is, since the Federal Reserve, which eschews an inflation targeting framework, has accumulated a comparable record of low and stable inflation." Yet some countries with explicit inflation targets still manage to stumble with the strategy--Brazil, Mexico, and the Philippines, for instance, write Rasche and Williams. The solution for insuring inflation targeting's efficacy seems to be one of an "announced explicit" goal. For the moment, however, the Fed isn't biting. Alan's homegrown policy choices are still the norm in fighting the inflationary beast. Will that change next year? If so, what will the bond market think?
BP Statistical Review of World Energy 2005 (June 14, 2005)
By BP plc.
Company research report.
No one needs to be told that crude oil is a strategic commodity of no small consequence in the global economy. But just in case someone forgot, yet another reminder was dispensed earlier in late June when oil touched a new all-time high of $60 a barrel in New York. Additional support for the belief that oil's not about to become "cheap" again any time soon, if ever, can be found in the pages of the new edition of BP's Statistical Review of World Energy for 2005, published on June 14. Among the tidbits of insight imparted: oil consumption growth last year was the largest in volume terms since 1976. In addition, consumption advanced by nearly 2.5 million barrels a day, which is more than double the 10-year average rate, BP's report notes. Among the other oily tidbits imparted:
* Global oil production exceeded 80 million barrels a day for the first time in 2004.
* Opec's share of global oil production continued to rise, advancing by 7.7% last year, or 2.2 million barrels a day more than the year before.
* Saudi Arabian oil production reached a record high of 10.6 million barrels a day.
Non-Opec production increased last year too, with Russia leading the way with a rise of 750,000 barrels per day.
* The largest absolute production declines were posted in the United States, where output fell by 160,000 barrels a day, and in the United Kingdom, which lost 230,000 barrels a day relative to the year previous.
* Unsurprisingly, Middle East proved oil reserves continue to dwarf reserves elsewhere in the world. At 2004's close, Middle East proved reserves were 733.9 billion barrels, or 60% higher than the rest of the world combined.
* U.S. oil imports jumped 5.3% last year over 2003, vs. a 5.0% rise for the world.
Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency? (June 6, 2005)
By Menzie Chinn, professor of public affairs and economics, University of Wisconsin; and Jeffrey Frankel, professor of capital formation and growth, Harvard University.
Working paper.
The dollar's position as the world's reserve currency is necessarily linked to the superpower status of the United States. Economically and militarily, America has no equal, a state of affairs that's more or less prevailed since World War Two. But the greenback's lofty perch isn't written in stone, and with the rise of the euro there has been a viable contender for the throne of late, or so we're told. Still, displacing the buck won't be easy. In fact, until recently, it was unthinkable. But what was unthinkable has recently become something less so in 21st century. What would it take to elevate the euro to the top of the currency mountain? A recently updated academic paper ponders the question and finds that toppling the almighty buck depends on two things: 1) the United Kingdom and enough other EU members join euroland so that it becomes larger than the U.S. economy; and 2) U.S. macroeconomic policy eventually undermine confidence in the value of the dollar, in the form of inflation and depreciation. Arguably, some of the latter has already arrive, whereas the former remains the stuff of speculation. In any case, a fall from grace isn't frequent among reserve currencies, but it does happen, write Chinn and Frankel. The descent of the British pound from reserve status in the early 20th century is just such a case. "The decline in the pound was clearly part of a larger pattern whereby the United Kingdom lost its economic pre-eminence, colonies, military power, and other trappings of international hegemony," they observe. "As some of us wonder whether the United States might now have embarked on a path of 'imperial over-reach,' following the British Empire down a road of widening federal budget deficits and overly ambitious military adventures in the Muslim world, the fate of the pound is perhaps a useful caution." Perhaps, although whatever fears harass the dollar are of fading concern in 2005. At the start of summer, the euro continues to look beleaguered, having dropped some 10% against the dollar year at the start of the new season. Then again, the pound didn't fade overnight. Tectonic shifts in the status of currencies is invariably the monetary equivalent of watching grass grow, or die.
Recession? Risks Developing, but Not Just Yet (June 6, 2005)
By John Hussman, Ph.D., Hussman Funds.
Essay.
The weaker-than-expected jobs report for May (a rise of 175,000 in nonfarm payrolls, down from a 274,000 gain in April) raised worries that the economy was stumbling. But John Hussman, who manages the market-beating Hussman Strategic Growth Fund, writes this week that it's not yet clear if it's time to panic. Last month's job report was "disappointing," he concedes. "But if you look at prior recessions," he continues, "they normally didn't start until job growth was even weaker--usually less than 1% growth in nonfarm jobs over the prior 12 months, and less than about 0.5% growth over the prior 6 months." Such depths haven't been seen, at least not yet, he notes. "At present, we've still got nonfarm payroll 1.5% over year-ago levels, and 0.8% over that level we saw 6 months ago." Hussman doesn't dismiss the potential for a recession. He does, however, point out four metrics that have been useful in signaling approaching recession in the past: 1) credit spreads wider than six months previous; 2) a "relatively flat" yield curve; 3) the S&P 500 trading below its level of six months earlier; 4) and the Purchasing Managers Index of manufacturing dropping below 50. The quartet of indicators "has been present at or near the beginning of every post-war recession," he claims. So what are these four saying today? Consensus is lacking, but there's a warning nonetheless. Credit spreads are higher and the yield curve is nearly flat, which suggests impending economic weakens. On the other hand, the S&P 500 is virtually unchanged from six months ago and while the manufacturing index has been falling it still remains above 50, albeit just barely. There are "legitimate concerns" in the metrics, Hussman counsels, "but they're still what I'd call 'developing' risks rather than outright warnings." The same goes for other indicators he discusses as clues about the future in his economic primer. "Suffice it to say that the overall economic picture is tending toward weakness," he writes.
Exchange Rate or Wage Changes in International Adjustment? Japan and China versus the United States (May 2005)
By Ronald McKinnon, professor of international economics, Stanford University.
Working paper.
Conventional wisdom advises that a weaker dollar will boost exports and pare imports. But the conventional wisdom is wrong, asserts Professor McKinnon, in a new paper, explaining that popular thinking on the matter "is based on faulty, although unfortunately widely accepted, theorizing that fails to come to grips with how the international dollar standard works." The charge is timely, given the growing pressure directed by Washington at China to let the yuan float. Taking the Chinese currency off its dollar peg will almost certainly strengthen the yuan relative to the dollar, delivering a free-market valuation adjustment that many in the U.S. say will boost American exports and lower imports, thereby narrowing the record U.S. trade deficit. But supporters of that forecast "provide no suitable conceptual model—let alone econometric evidence—that this would significantly reduce China’s trade surplus with the United States," McKinnon writes. The strategy to convince China to float its currency, in short, may not deliver the results that are so widely expected, he warns. Why? In essence, McKinnon says that accurately predicting trade flows is highly dependent on the underlying state of the economies in question. Looking exclusively at exchange rates, by contrast, overlooks a large slice of the relevant variables. "The high-saving countries in Asia and Europe (and including Canada), all creditors of the low-saving United States, face the specter of a growth slowdown or outright deflation should their currencies appreciate." This fact, rather than the exchange rate between the dollar and other currencies, will determine trade flows. In sum, the prevailing state of affairs in China and elsewhere means that little, if any, progress on trimming America's trade deficit will come by forcing the yuan to float, he counsels.
Asset Prices and Monetary Liquidity (May 27, 2005)
By Roger W. Ferguson, Jr., vice chairman, Federal Reserve Board.
Prepared Remarks, Deutsche Bundesbank Spring Conference, Berlin.
Is monetary liquidity, when delivered in excess, capable of distorting markets? Ferguson weighs in on the issue, although claims the results are "mixed, at best." But he doesn't pass the buck entirely. Two intriguing observations include looking at equity prices and real estate values after the Fed pumps up the money supply. "The link between the growth rate of liquidity and changes in real equity prices at frequencies beyond very short term appears to be tenuous at best," he observes, and refers to a chart showing "no meaningful correlation" between the growth rate of M3 money supply and equity prices in 16 industrial countries. There's a bit more traction between real estate prices and money supply, however, or as Ferguson terms it: there's more of a "definite" pattern between the two. "The two series exhibit a small positive correlation that is statistically significant."
"Bretton Woods II" is not a Monetary System, it’s an Excuse( May 24, 2005)
Marshall Auerback, international portfolio strategist, David W. Tice & Associates, LLC
Essay, PrudentBear.com.
Some have dubbed the current trade relationship between the U.S. and Asia, namely Japan and China, as part of Bretton Woods II (BWII). This a reference to the managed currency regime that prevailed in the world economy from 1945 through 1973, when it collapsed under the weight of rising inflation and other economic pressures. Today, the U.S. imports much more than it exports, and this trade gap is rising. Yet the leading foreign holders of dollars, Japan and China, seem more than happy to ship goods to the U.S. in return for greenbacks. As the dollars build up in foreign central bank coffers, the host countries fund America's trade gap and help keep interest rates lower in the U.S. than they'd otherwise be. Is this international relationship the basis for a new currency system? Or is it something less? Whatever you call, it's not long for this world, Auerback predicts. The Bank of Japan is now sending out signals that the end of the arrangement, or whatever it is, may be near, he writes. "Indeed, there are signs that the Bank of Japan (long a key player in perpetuating 'BWII') is hinting that enough is enough."
Alpha-Beta: Separation, Transportation and Recombination (May 2005)
By Bruce Brittain, James Keller, John Loftus, and James Moore, Pacific Investment Management Company (PIMCO).
Essay.
Separating manager skill (alpha) from market risk/return (beta) is gaining popularity in money management. So-called portable alpha strategies, i.e., isolating alpha in the markets and using it elsewhere to re-engineer risk/return dynamics, is especially favored these days, the authors report. Driving the trend is the expected low return from the major asset classes (stocks, bonds) and the widening availability of derivatives. "Now investors are debating not just whether to separate alpha from beta, but how to put the manager’s alpha to better use," the paper notes. "This concept of separating alpha from beta has been energized by the rapid growth of futures and swaps markets that can offer nearly pure market exposure to beta with apparently low transaction costs." While a successful portable alpha strategy can help investors overcome the limitations of market conditions, it's no easy road to riches. "By separating alpha from beta, investors can focus on finding high alpha managers irrespective of asset class," they advise. "Portable alpha strategies may represent a more efficient allocation of capital relative to a traditionally structured portfolio, but they are considerably more complex to manage. Implementation issues require serious consideration and study before engagement."