“By searching the sky now, me and other asteroid hunters hope to give us the early warning – ideally decades – that we need. But that strategy of focused searching hasn’t stopped people from thinking about what we might do if an asteroid was on its way toward us.” ― Carrie Nugent
This week’s piece is both a bit short and important. In the second half of the piece, we share a critical identity in understanding the fundamental drivers of the US yield curve.
We have put in much time and thought into better understanding the economic fundamentals driving the yield curve and put forth a seemingly straightforward identity that, we hope, can better explain shifts in the yield curve.
OECD Leading Indicators and the Cyclical Trend
The below chart is that of the year-over-year change in the OECD Leading Indicator Index for major economies and that of the yield on the US 10-year Treasury bonds lagged by 3 months.
The leading indicators index tends to lead long-term yields by, approximately, three months.
In 2018, long-term yields over shot to the upside based on the leading indicators index. Today, the index is signaling that yields are too low and on a cyclical basis economic activity in the major economies has bottomed and is turning up.
The below chart is that of the leading indicators index versus the the MSCI All Cap World Index excluding US stocks lagged by nine months. Global stocks, excluding the US, tend to lag the leading indicators index by six to nine months.
The leading indicators index suggests that non-US stocks are close to bottoming on a cyclical basis.
The Secular Trend Behind the Yield Curve
In the below chart, the orange line is the 10Y – 2Y US Treasury yield curve and the magenta line represents US private savings less US private investment.
Private savings less private investment approximates the shape of the yield. Given, however, the fractional reserve system of banking, the private savings surplus or deficit has some slippage that does not capture excess credit creation by the banking system. Nonetheless, it is a good enough proxy for the purposes of approximating the direction of the yield curve.
What does a private savings surplus or deficit have to do with yield curve?
At the start of an economic expansion, private savings are plentiful, having been replenished following a recession as households and corporations repair their balance sheets by increasing savings and scaling back investments. As private sector balance sheets are repaired, confidence slowly returns and a new investment cycle commences.
With plentiful savings, in the form of deposits and cash like holdings, short-term interest rates are pressured lower. Reduced appetite to invest in longer maturity assets following a recession pushes up longer-term interest rates to entice savers to invest in longer duration assets. With an upward sloping yield curve, the banking system is incentivised to undertake maturity transformation by borrowing short and lending long.
As savings are drawn down, the declining supply of capital at the short end of the yield curve places upward pressure on short-term interest rates. At the same time as capital moves towards longer duration assets, the increased supply pushes down interest rates at the long-end. The continued maturity transformation undertaken by banks by borrowing short and lending long eventually leads to a flattening of the yield curve.
The yield curve inverts when increasing investments have exhausted private sector savings and the competition for marginal capital available at the short-end pushes up short-term interest rates.
The yield curve eventually steepens as appetite for longer duration investments collapses and an increasing number of investments made during the expansion become impaired. Impairments are caused by (1) investments no longer being profitable (on a net present value basis) due to the higher short-term rates; or (2) revelations of misallocation of capital into speculative or ponzi investments that sustained only because of the abundance of capital.
The drop in capital investments precipitates a recession and the economy once again has to enter a phase of balance sheet repair before the economy re-enter an expansionary phase.
Economic Identities
(1) GDP (Y) = Consumption (C) + Government Spending (G) + Investment (I) + Exports (EX) – Imports (IM)
(2) Y – C – Tax (T) = G – T + I + EX – IM
(3) Private Savings (PS) = Y – C – T.
(4) PS = G – T + I + EX – IM
Current Account (CA) = EX – IM
(5) Savings of the Government (SG) = T – G
(6) PS = I + CA – SG
Putting It Altogether
Private sector savings in the US can be replenished by (1) increased foreign investment into the US, (2) the current account going from a deficit to a surplus or (3) the government increasing its spending.
If we assume, the current account deficit remains around current levels, private savings will only be replenished through increased (foreign) investment or increased government spending.
Loosely, government spending and foreign investment are two sides of the same coin. The US has historically financed its fiscal deficits with the capital foreigners have invested in US Treasury securities. Foreign investors, however, may be unable or unwilling to finance the US government for a wide variety of reasons including:
(1) a US dollar shortage leading to stress or turmoil in their local economies;
(2) protectionist policies of the Trump Administration; or
(3) the unfavourable risk-to-reward profile of financing ever increasing deficits at record low interest rates.
If all foreign investors want or need is higher carry, the yield curve will simply steepen as it has done in the past. In the no-longer remote chance that foreigners are unable or unwilling to finance growing US deficits for reasons other than higher carry, however, what then is the release valve that will enable private sector savings to be replenished?
Should we be surprised that modern monetary theory (MMT) has become part of the broader economic policy discussions and no longer a fringe theory?
MMT is a whole other can of worms and deserves a discussion on its own that we will return to at a more opportune time.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.