It's the zero bound yield curve, stupid!

November 3, 2015 07:46 AM
Bad money drives out good money

Capitalism would not work well if Fed Funds and 30-year Treasuries co-existed at the same yield, nor if commercial paper and 30-year corporates did as well. Investors would have no incentive to invest long term. What central bank historical models fail to recognize is that over the past 25 years, capitalism has increasingly morphed into a finance dominated as opposed to a goods and service producing system.

If a government or a too big to fail government bank can borrow near 0%, then theoretically it should have no problem making a profit or increasing real economic growth.
It is not only excessive debt levels, insolvency and liquidity trap considerations, then, that delever both financial and real economic growth, it is the zero-bound nominal policy rate, the assumption that it will stay there for "an extended period of time" and the resultant flatness of yield curves which may be culpable. As a result, in the case of banks, their "Nims" or net interest margins are narrowed as Chart 1 suggests. It stands to reason that when bank/finance profit margins resulting from maturity extension are squeezed (curve flattening) then overall corporate profits are squeezed as well.

This new Gresham’s corollary applies to other finance based business models as well. If long term liability based pension funds and insurance companies cannot earn an acceptable "spread" from maturity extension – and in the case of zero based policy rates – cannot therefore earn an acceptable return on their investments to cover future liabilities, then capitalism stalls or goes in reverse. Profit growth or profits themselves come down and economic growth resembles the anemic experience of Japan; pension funds begin to cut benefit payments as recently threatened in Puerto Rico and Illinois, reducing disposable personal income.

Even unions are not exempt, as preliminary threats to cut benefits by 50% by the Teamsters show. Corporate profits may be further reduced as an increasing number of companies using defined benefit plans are forced to increase contributions to wobbly and underfunded balance sheets. Individual households must also save more and consume less if the return on their savings is reduced by a flatter yield curve.

My primary thesis, supported by the above examples, remains that capitalism does not function well, and profit growth is stunted, if short term and long term yields near the zero bound are low and the yield curve inappropriately flat. Chart 2, which graphically displays yield curve flattening cycles over the past 20 years, shows a remarkable one to two year leading correlation to increasing/decreasing rates of profit growth seen in Chart 1, even when the flattening results from lower long term yields as opposed to central bank tightening as in 1993-1997.

Chart 2: U.S. Yield Curve (1993-2015)

Chart 2: U.S. Yield Curve (1993-2015)

When our modern financial system can no longer find profitable outlets for the credit it creates, it has a tendency to slow and begin to inhibit economic and profit growth in the overall economy. With a near zero interest rate policy, central banks zero out the cost of time, bidding up existing asset prices, but failing to create sufficient new assets in the real economy.

When our modern financial system can no longer find profitable outlets for the credit it creates, it has a tendency to slow and begin to inhibit economic and profit growth in the overall economy.

Global central bank staff models will likely not validate this new Gresham’s corollary. Former Fed chairman Ben Bernanke blamed a mild policy rate increase in the midst of the 1930s for an economic relapse, and a lack of credit expansion for Japan’s lost decades 60 years later. He avoided the potential influence of low yields themselves, claiming then, as now, that green-shoots growth would eventually restore normality to savers. But all central banks should now commonsensically question whether ultra-cheap money continually creates expansions as opposed to reducing profit margins and hindering recovery. Recent experience would confirm the latter thesis.

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