Monday, August 23, 2010

The Problem with Following an Indicator without Understanding the Fundamentals Behind It

One of my favorite indicators used to be the yield cure. You could pretty much set your boom-bust cycle clock around it. For this current cycle, I have tossed it in the trash bin. Most others have not followed such a course, even the Cleveland Federal Reserve. (Although,I guess, it is not surprising that the Cleveland Fed shows up as clueless)

In the old days if the curve was negative (short-term rates higher than long-term rates) the economy was in trouble or headed toward it. If the curve was positive (short-term rates lower than long-term rates) happy days we're here, again.

Peter Cohan at DailyFinance explains the thinking on this and applies it to the current yield curve:
...the yield curve -- the interest rates paid on different durations of Treasury bonds -- is sloped upwards so much that the chances of such a double-dip recession are a mere 15.5%, according to the Federal Reserve Bank of Cleveland.

How The Yield Curve Predicts The Economy

The theory behind the yield curve is well-explained in William Greider's 1987 bestseller about the Federal Reserve, Secrets of The Temple. The Fed sets short-term interest rates and the market sets the longer-term ones. These differing rates over time can be depicted as a curve that either slopes up or down. If the yield curve is positive sloping -- in other words, when short-term rates are lower than long-term rates -- then the economy is likely to expand.

That's because under those conditions, banks will be rewarded by the spread between rates for borrowing money in the short-term and lending it out for later repayment. Simply put, an upward sloping yield curve makes it profitable for banks take money at a very low rate and to lend it to business and individuals who will repay it later at a higher rate. Such lending generally puts more money into the economy and leads to economic growth.

Conversely, when the Fed wants to cool off an overheated economy, it raises the short-term interest rate to the point where the yield curve slopes down -- creating a so-called inverted yield curve. When this happens, the spread I mentioned above turns negative and it is more profitable for banks to hold onto their cash.

How so? If they were to lend it out under such conditions, they would be paying a higher interest rate to attract deposits than they would receive from people to whom they lent it out. Under those conditions, rather than lose money on lending, banks will hoard their cash. That reduction in the amount of money flowing into the economy induces an economic slowdown.

What The Yield Curve's Saying Now

Today, this theory predicts an economic expansion, because, as Bloomberg reports, the gap between 2-year and 10-year Treasury notes -- the short and the longer term durations -- is 2.11 percentage points. While this spread is narrower than February 2010's record 2.91 percentage point spread, it's nearly double the average since 1990. In other words, we have a very positive yield curve now.

Bond traders note that the last seven economic contractions have been preceded by an inverted yield curve, so they're not buying the idea that a downturn is imminent. But if we're not heading into a recession, how much will the economy grow? The Cleveland Fed's projections of the three-month Treasury bill rate to 10-year note yield suggest slow, but positive economic growth -- up 1.14% over the next year.

If that turns out to be right, there won't be a double-dip, but it won't feel much like economic growth. And if that slow growth leads to a moribund job market, it may take more than a year for us to get out of the recession that NBER said started in December 2007 -- and that's still, technically, going on.
Here's the problem with Cohan's analysis, that of the Cleveland Fed and "bond traders." They are looking at the historical empirical association between the yield curve and the economy, but not understanding the fundamentals behind it. Even though Cohan, above, does a good job of expalining the fundamentals.

In the past, a positive yield curve meant that banks loaned out cheap short-term money at higher rates long-term, just as Cohan/Greider explain. This caused money to enter the economy and fuel a Fed manipulated boom.

This time around the yield curve is positive, but banks are parking the cheap money as excess reserves and not putting it into the system. Thus, the simple correlation that Cohan, the Cleveland Fed and "bond traders" are relying on that a positive yield curve causes a boom in the economy won't work this time because the money available at the short-end is not entering the system.

As I have said before, the quants behind Long Term Capital Management and the subpime mortgage blew up huge portfolios because behind all their complex whiz-bang formulas they are essentially looking at correlations without understanding why those correlations exist and when they might fail.

The great Austrian economist Carl Menger observed more than a century ago that economics was not a science of empirical formulations, but a science of deduction. Quants seem to have to learn this on their own by blowing up billions of dollars, if not trillions, by riding a correlation that has run its course. Note: This does not mean that an economist should not look at empirical data. It simply means that empirical data does not have constants like water freezing at 32 degrees. No correlation should be viewed as a constant in the science of economics. Instead, an economist should look at empirical data to see if there is any deductive reason that can explain why certain data to correlates, and to understand through deductive reasonning, when the correlation may fail. In fact, no empirical data should be considered of any value unless you have found at least one situation under which the correlation can fail. If you haven't found at least one fail point, you can't possibly understand the correlation completely.

1 comment:

  1. Totally agree. I keep rolling my eyes when I see Mark Perry point to this "indicator". This recession started because of the classic money supply girations of the Fed, but it's length is a separate issue. The length, like the Great Depression, is caused by federal regulatory policy. Obama's market meddling, just like Hoover/FDR and the Japanese in the 90s, is preventing the economy from returning to an efficient allocation of resources. Hopefully after the November elections we can move from our current madness to the normal idiocy we expect from Congress.