``The interest rates for more distant maturities are normally higher the further out in time. Why? First, because lenders fear a depreciating monetary unit: price inflation. To compensate themselves for this expected (normal) falling purchasing power, they demand a higher return. Second, the risk of default increases the longer the debt has to mature.-Gary North
The first structural factor, the record steep yield curve, should be a familiar theme to those who regularly read my outlook.
This accounts for as the “profit spread” from which various institutions take advantage of the “borrow short term and lend or invest in long term assets”[1].
The Yield Curve (YC) is a very dependable tool for measuring boom bust cycles (see figure 2).
That’s because artificially lowered interest rates, a form of price control applied to time preferences of the individuals relative to the use of money, creates extraordinary demand for credit and fosters systematic malinvestments or broad based misdirection of resources within markets and the economies.
Figure 2: Economagic.com: Yield Curve and the Boom Bust Cycle in the S&P 500
Sins Of Omission: The Influences of Habit or Addiction
It’s fundamentally misplaced to also conclude that just because balance sheet problems exist for many consumers, particularly for developed economies in the West, as they’ve been hocked up to their eyeballs on debt, that they would inhibit themselves from taking up further credit to spend. This also applies to some corporations.
Such presumption fatally ignores individual human action, particularly, for people to develop and sustain irrational habits. Some of these habits grow to the extent of addiction, which could have a beneficial (reading) or negative or neutral effect (mowing lawns). Albeit, addiction has a predominantly negative connotation.
While addiction[2] has many alleged modal causes, e.g. disease, genetic, experimental, and etc., some models have been argued on the basis of purely psychology, specifically:
-choice [The free-will model or "life-process model" proposed by Thomas Szasz],
-pleasure [an emotional fixation (sentiment) acquired through learning, which intermittently or continually expresses itself in purposeful, stereotyped behavior with the character and force of a natural drive, aiming at a specific pleasure or the avoidance of a specific discomfort."- Nils Bejerot]
-culture [“recognizes that the influence of culture is a strong determinant of whether or not individuals fall prey to certain addictions”]
-moral [result of human weakness, and are defects of character]
-rational addiction [as specific kinds of rational, forward-looking, optimal consumption plans. In other words, addiction is perceived as a rational response to individual and/or environmental factors. There wouldn’t be an addict or substance abuse problem, if those affected are disciplined enough to correct habit abuses.]
If affected persons, in recognition of such problems, simply applied self-medication or took preventive measures to avoid the worsening development of negative addiction, then obviously we wouldn’t have addiction problems at all! But certainly this hasn’t been true.
From a psychological standpoint, it would seem quite apparent that addiction is largely a stimulus response feedback mechanism or very much a behavioural predicament.
In other words, negative addiction is fundamentally a choice between temporal happiness over future consequences (frequently adversarial outcomes) or where habit interplays with choices, rational alternatives, environment, moral frailty, cultural influences or seductiveness of pleasure vis-a-vis normal behaviour.
Simply put, there is an incentive for people to develop different forms of addictions.
Applied to the markets or the economy, what if the source of profligacy [or Oniomania[3] or compulsive shopping or compulsive buying], a form of addiction, stems from government initiatives, by virtue of artificially suppressed interest rates?
And what if government induces people to spend on things they can’t afford with money they don’t have, out of the desire to fulfil economic ideology or to promote certain industries?
Will the teetotaller refuse government’s offer of free drinks?
How much of government induced behaviour from reckless policies will force individuals and businesses to take the low interest rate bait?
And this seems to be the story behind the yield curve.
The Stock Market And The Yield Curve Over The Long Term
Notice that every time the long term yield (30 year treasury constant maturity-red) materially diverges from the short term yield (1 year treasury constant maturity-blue) to form a steepened yield curve (black arrow pointed upwards), the S&P 500 (green) blossomed.
On the other hand, inverted yield curves, where short term yields had been higher than the long term yields (green arrow pointed downwards), had preceded recessions and severe market corrections.
Like normal yield curves, the yield curve’s impact on the economy has a time lag, a 2-3 year period.
Even the October 1987 Black Monday crash appear to have been foreshadowed by an account of relatively short inversion in 1986.
And the inflation spiral of the late 70s saw short term rates race ahead of short term rates for an extended period.
So why does an inverted yield curve occur?
Because the debt markets reveal the amount or degree of misallocations in the market ahead of the economy.
According to Professor Gary North
``This: the expected end of a period of high monetary inflation by the central bank, which had lowered short-term interest rates because of a greater supply of newly created funds to borrow.
``This monetary inflation has misallocated capital: business expansion that was not justified by the actual supply of loanable capital (savings), but which businessmen thought was justified because of the artificially low rate of interest (central bank money). Now the truth becomes apparent in the debt markets. Businesses will have to cut back on their expansion because of rising short-term rates: a liquidity shortage. They will begin to sustain losses. The yield curve therefore inverts in advance.”[4]
This means that when consumers and businesses compete for short term funds, demand for short term money raises interest rates. Nevertheless, as the fear of inflation recedes, “an ever-lower inflation premium”[5] forces down long term yields.
As a caveat, since corporations operate on the principle of a profit and loss outcome, they’re supposedly more cautious. But this hasn’t always been the case. And it should be a reminder that a fallout from an imploding bubble does not spare so-called blue-chips, as in the case of the US investment banking industry, which virtually evaporated from the face of earth in 2008.
Industries that have been functioned as ground zero for bubbles are usually the best and worst performers, depending on the state of the bubble.
Figure 2: Business Insider: Falling Net Debt To Cap
Figure 2 is an interesting chart.
Interesting because the chart shows of the long term trend of the S & P 500 Net debt to Market cap-which has been on a downtrend, for both the overall index (red spotted line) and the ex-financials (blue solid line).
Since it is a ratio, it could mean two things: debt take up has been has been falling or market cap has been growing more than debt. My suspicion is that this has been more of the growth in market cap than of debt (since this is a hunch more than premised on data, due to time constraints, I maybe wrong).
In addition, since the tech bubble, corporate debt hasn’t grown to the former levels in spite of the antecedent boom phase prior to the crash of 2008.
Nevertheless, the substantially reduced leverage from corporations, particularly the net debt (red spotted line) which has reached the 2005 low, suggest of a recovery. This could signify a belated play on the yield curve.
Prior to the recent crisis, the S&P net debt began to recover at the culminating phase of the steep yield curve cycle.
Could we be seeing the same pattern playout?
Commodities And The Yield Curve
Finally, the link of the yield curve relative to US dollar priced commodities has not been entirely convincing. (see figure 3)
Figure 3: Economagic: Yield Curve and the Precious Metals
Over the span of 3 decades, we hardly see an impeccable or at least consistent correlation.
Precious metals in the new millennium soared during the steep yield curve. But it also ascended but at much subdued pace during the inversion.
In the late 70s precious metals exploded even during inverted yield curve. While it may be arguable this has been out of fear, it does not fully explain why gold and the S & P moved in tandem see figure 4.
Figure 4: Economagic: Precious metals and the S&P 500
Moreover, between the 80s and the new millennium, correlations have been amorphous.
And perhaps as we earlier averred this could have been due to the formative phase of globalization where much of liquidity provided by the US Federal Reserve had been “soaked up” by the inclusion of China and India and other emerging markets in global trade as a result of policies from Reaganism and Thatcherism and the collapse of the Soviet Union.[6]
The various bubbles around the globe, during the said period, serve as circumstantial evidence of the core-to-the-periphery dynamics.
Overall, as the yield curve remains steep, we believe that the upward thrust of markets should continue to hold sway as the public will be induced to take advantage of the “profit spread” as well as with central banks continued provision of stimulus conditions that would revive the compulsive manic behaviour seen in persons afflicted by varied forms of addiction.
[1] See Does Falling Gold Prices Put An End To The Global Liquidity Story? and Why The Presidential Elections Will Have Little Impact On Philippine Markets
[4] North, Gary; The Yield Curve: The Best Recession Forecasting Tool
[5] North, Gary; When the Yield Curve Flips. . . .
[6] See Gold: An Unreliable Inflation Hedge?
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