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Greenspan Conundrum 2.0: Are the Markets Warning of Imminent Danger?

 5 min read / 

Last Friday, the US Federal Reserve cleared the final hurdle on the path to an interest rate hike. The first, as many analysts predict, of three or four increases this year depending upon the inflation rate growth.

That hurdle was the jobs report, which exceeded expectations by registering an additional 235,000 employed citizens, accompanied by a welcome growth in wages; a factor that has lagged behind throughout the economic recovery.

In line with comments made by Fed Chair Janet Yellen, who signalled that a March hike is “likely appropriate” if “employment and inflation are continuing to evolve in line with our expectations” and New York Fed President William Dudley who stated that the case for an interest rate increase is “a lot more compelling”, the probability of such an action at the next Federal Open Market Committee meeting on the 14-15th March has been priced in at 100%.

One concerning trend, last witnessed between the years of 2004-2006 preluding the global financial crisis, is that despite the sensitivity of short-term Treasury bond yields to adjustments in monetary policy, the yields on longer duration Treasury bonds have remained relatively static.

This has created a flattening of the yield curve due to the reduction of spread between the 2-year and 10-year bond yields, known as the ‘Greenspan Conundrum’ after Alan Greenspan who first alluded to the problem during his tenure as Fed Chair.

What Is the Greenspan Conundrum?

Raising short end rates does not shift long-term yields. As a result, the yield curve becomes flat and in some cases, inverted. This is important as an increase of spreads usually indicates that investors are optimistic about the growth rate of the economy while, on the other hand, a narrowing of spreads implies a weakening economic outlook.

There are numerous reasons for this phenomenon. Domestically, when the Federal Reserve increases interest rates borrowing costs grow higher for consumers and businesses. With variable rate loans dependent upon the benchmarks that are tied in with this rate, an increase in interest rates escalates the cost of servicing debt, hence decreasing consumer spending. In turn, this reduces economic growth and inflation, indicators which guide the movement of the long duration yield. As such, a policy of increasing rates resulting in lesser growth and inflation has lowered the 10-year yield.

The BOJ Example

In 2001, the Bank of Japan launched a quantitative easing programme designed to stimulate growth following the Asian financial crisis. This resulted in a suppression of bond yields, and unbeknown to the market at the time, also had an adverse effect on long term US treasuries. In addition, the major Asian economies sought to boost foreign reserves in order to defend against capital outflows in the event of a future crisis. These countries grew reserves by issuing debt to their citizens to mobilise domestic saving, before using the income to buy US Treasury bonds. Very simply, inflows into long-term rates drove down yields independent of changes in US monetary policy.

Both of the aforementioned domestic and international factors set the scene for these abnormal conditions, which emerged when then-Fed Chair Alan Greenspan began a series of interest rate hikes in order to tame the booming real estate sector, in 2004. Short-term yields increased while long-term yields fell, hence a conundrum that dumbfounded the brightest minds in the industry.

The Significance

This trend is problematic as it highlights the Fed’s inability to control longer-term rates, which are usually set by global market participants. It may also indicate that the timing of a rate hike is inappropriate, which historically only occur with both growth and inflation above trend.

Both of these factors usually increase the long-term yield, which allows short-term yields to increase without flattening the spread curve. If an interest rate increase causes the spread to decrease, then this may indicate that there are insufficient growth and inflation to justify the hike.

A flattening of the curve can, in effect, mean the onset of economic decline:

(Shaded areas indicate US economy in recession. The blue line indicates the yield spread between the US 2-year short dated and the US 10-year long-dated treasury bonds. Source: Federal Reserve Bank of St Louis)

As the above chart shows, a reduction in the yield spread curve has in the past resulted in a period of potent economic downturn. Starting firstly with the early 1980s US recession, through to the financial crisis beginning in 2007.

Worryingly, whenever the above graph reached the sub-zero percent relationship, the economy has fallen into recession. The current trajectory of this curve is to once again decline to 0% within the next couple of years, which may foreshadow a new period of economic misery.

While the Federal Reserve committee remains on course for a further two or three interest rate hikes this year, a lot of attention will be paid to the re-emergence of this conundrum. The next financial crisis or even simply a stock market correction is a case of when, not if, and the above graph could be key to predicting this imminent danger.

2 Comments

2 Comments

  1. Manuel Pinto

    March 14, 2017 at 10:31 PM

    Liked the aprouch, Good

    • Daniel Appleby

      March 15, 2017 at 9:32 AM

      Thank you. Pleased that you enjoyed reading it! 

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Global Affairs

BP and Iraq Sign Development Deal for Kirkuk Oil Fields

 2 min read / 

BP Kirkuk deal

Iraqi Government and British energy giant BP have signed an agreement for the future development of the Kirkuk oil fields in Northern Iraq.

A statement on the Iraqi Oil Ministry’s website said the “memorandum of understanding” between the government and the London-based oil company would enable further development of the oil fields as well as “to open a new page of work” for the North Oil Company, a subsidiary of the Oil Ministry, on “solid foundations”.

BP Director, Michael Townsend, said the company would conduct the necessary surveys and prepare the required statistics.  He claims the company will increase production by 750,000 barrels of oil a day.

The Kirkuk Oil Field, discovered in 1927, is one of the largest oil fields in the world, producing half of Iraq’s oil exports, a reported million barrels a day. However, it has also been a wellspring for local instability: the fields had been seized in 2014 by the Kurdistan Regional Government, who piped oil across the Turkish border, a few hundred kilometres to the north. The fields were only retaken by government forces in October 2017.

Baghdad is attempting to reassert its authority throughout its provinces and according to Iraq’s Minister for Oil, Jahbar Ali al-Allaibi, Thursday’s announcement will “speed up the rehabilitation process”.

During the Saddam Hussein era, the fields suffered irrecoverable damage due to poor management. Excess production was reinjected back into the ground making Kirkuk’s oil thicker and therefore harder to extract.

On Wednesday al-Allaibi met with Britain’s ambassador, John Wilkes, where according to the ministry’s website, they talked about joint cooperation between the two countries in the oil and gas industry.

Keep reading |  2 min read

America

Trump’s Presidency and Russian Relationship: The Future

 4 min read / 

Trump Russia

Much has been said about Donald J. Trump’s love affair with Russia. Questions deserve a thorough and honest investigation. As distasteful and risky it may be, the best outcome of the enquiry is accusations continue to swirl, Trump limps through three more years, and in 2020, he is crushed at the ballot box. The world moves on. If removed from office, odds are Trump whips his base into a frenzy. Only the height and duration of civil unrest is in question. A worse case is that Trump emerges emboldened, eager to settle Putin’s longstanding challenge.

Putin Mocks Trump

The competition is real. Putin’s economic and political dominance gnaws Trump. Putin knows this. So, he taunts the President and dares Trump to employ the same ruthless tactics he exploited to consolidate power and possibly become the world’s richest man. Since Trump only sees green, he took the bait. The race is on to be the world’s first trillionaire.

Russia’s population is 142 million. Its $3.86trn translates into a measly $26,900 per capita GDP. In contrast, the 326 million people of the United States generate $18.62trn in GDP, nearly five times Russia’s total. The US per capita GDP of $57,600 more than doubles Russia’s. Despite Russia’s meek economy and reports  that Putin has embezzled up to $200bn in assets, Putin remains incredibly popular in Russia.

The apathy regarding this unparalleled heist makes Trump and Putin salivate over what they could jointly pilfer from the world economy. To advance their contest, the pair will identify a common threat. US-Russia relations will warm. Under the guise of “Peace through strength,” Russian sanctions will be lifted, and the Magnitsky Act repealed.

The administrative state in retreat, animal spirits will run wild. Trump’s name will be emblazoned across the globe. Countries desperate for jobs will be compelled to forge deals sponsored by Putin and Trump. Ethics be damned, the race to the bottom of the $120trn global economy will prompt a wave of corruption never seen before. Every facet of human decency will be compromised: environmental regulations, free and fair-trade by-laws, intellectual property, and human rights protections. The collusion is real.

In time, complicity will turn to double-crossing. It’s the Trump-Putin way. Makeshift “me-first” trade deals will collapse. Boycotts, divestitures and sanctions will be commonplace. Cooperation will evaporate. New political boundaries will be drawn with little world condemnation.

It doesn’t have to happen this way. Patience is a virtue. The checks and balances of the three branches of government are powerful mechanisms to thwart overt corruption.

Yet, for the impatient who seek Trump’s impeachment or removal via the 25th Amendment, be careful what you wish for. Only Trump can tame his army. To assume Trump will plead mercy at the feet of the administrative state contradicts Trump’s lifelong persona. He will relentlessly counterpunch and encourage his followers to do likewise. The short and long-term political and social risks are astronomical.

If Trump stems the tide, consolidates power and aggressively partakes in Putin’s race for two terms, the risks outstrip his forced removal. The consequences will be multi-generational.

Rope-a-Dope Is the Key to Containing Trump

The only path that possibly prevents extensive collateral damage is to check Trump into policy oblivion. Legislators must play rope-a-dope for as long as it takes, even three years if necessary. If Democrats take back both houses in 2018, the tactic will not set up Trump and his base for a final knock-out punch in 2020. For that to occur, numerous members of the GOP must join the effort. They too must throw periodic jabs at Trump then absorb a barrage Trump’s counterpunches.

With foes in every corner, even Trump – the self-proclaimed greatest counterpuncher in history—and his base will wear themselves out well before 2020. Then the decisive knockout punch can be delivered at the ballot box—without collateral damage.

Trump is severely wounded. If he gracefully and peacefully surrenders the Presidency, great. But don’t expect it. Rope-a-dope deployed by both parties is the countries best hope for a peaceful end to the Trump Presidency. Any other scenario risks the once unthinkable; an ‘American Spring’.

Keep reading |  4 min read

Europe

May Meets Macron

May Macron

The UK prime minister agreed to pay £44.5m towards tighter border security at Calais.

Editor’s Remarks: The French president arrived in the UK for the Anglo-French summit amid widespread complaints from the Tory party about just why Britain is paying another £44.5m for tighter security in France. One Tory MP pointed out that this addition brings the total figure the UK has paid to France in recent years up to £170m. France, meanwhile, says that the amount is necessary because the migrants in Calais are trying to get to the UK, who must, therefore, contribute towards their costs. The talks were also consumed by the imminent task of reaching consensus over the UK’s trade deal with the UK after Brexit goes through.

Read more on Europe:

Keep reading |  1 min read

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