James Pethokoukis

Politics and policy from inside Washington

Watch out for (yield) curves: Kudlow vs. Goldman

Dec 23, 2009 17:54 UTC

The super-steep yield curve is hinting at a powerful recovery in 2010, so says Larry Kudlow:

When the curve is wide and upward sloping, as it is today, it tells us that the economic future is good. When the curve is upside down, or inverted, with short rates above long rates, it tells us that something is amiss — such as a credit crunch and a recession.

The inverted curve is abnormal, the positive curve is normal. We have returned to normalcy, and then some. Right now, the difference between long and short Treasury rates is as wide as any time in history. With the Fed pumping in all that money and anchoring the short rate at zero, investors are now charging the Treasury a higher interest rate for buying its bonds. That’s as it should be. The time preference of money simply means that the investor will hold Treasury bonds for a longer period of time, but he or she is going to charge a higher rate. That is a normal risk profile.

The yield curve may be the best single forecasting predictor there is. When it was inverted or flat for most of 2006, 2007, and the early part of 2008, it correctly predicted big trouble ahead. Right now it is forecasting a much stronger economy in 2010 than most people think possible. So there could be a mini boom next year, with real GDP growing at 4 to 5 percent, perhaps with a 6 percent quarter in there someplace. And the unemployment rate is likely to come down, perhaps moving into the 8 percent zone from today’s 10 percent.

Unless it isn’t, as David Goldman predicts:

The yield curve is at record steepness. I think that’s an overreaction. In fact, the steep yield curve in the present environment is NOT a harbinger of recovery — it’s a brake on recovery because it encourages banks to own Treasuries rather than risky assets.

Goldman then goes on to list 9 other reasons why he doesn’t think the recovery will be particularly strong.


I have always liked Larry Kudlow’s optimistic view of the future and, frankly, I see nothing wrong with his analysis of the current yield curve. David Goldman, on the other hand, is a classic bond trader, forever bearish and always looking for clouds on the horizon, however small, to justify heading indoors. As for this current recession being “different”, as in “It’s different this time” – oh please. The equity rally of the late 90′s, the real-estate boom of the mid-00′s, virtually all the pundits said it was different this time. Of course they were all proven wrong, spectacularly so. Bet on inertia, bet on human nature, bet on optimism: Larry Kudlow has it right, once again.

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The ‘mirage’ economic recovery

Dec 15, 2009 19:26 UTC

Gallup’s chief economist, Dennis Jacobe:

We’ve just gone through the worst financial crisis since the Great Depression, and economies don’t recover from that kind of thing overnight.

What led to this artificiality was that governments and monetary institutions around the world, led by the U.S. Federal Reserve, took unprecedented actions to mitigate the effects of the financial crisis.  … In addition, the United States has undertaken an unprecedented amount of spending, ranging from TARP [the Troubled Asset Relief Program] and the auto industry bailout to the stimulus program and expansion of the social safety net. As a result, future federal budget deficits are also going to be unprecedented for years to come. Combined, these fiscal and monetary policies have led to sharp declines in the value of the dollar, a surge in commodity prices, and even serious questions about the role of the dollar in the global economy.

All of this seems to have worked in the short term, and the world economy is much better off in terms of its financial stability than it was a year ago.  … A lot of what we’re currently seeing is more of a mirage than reality — and people should be wary of the false signals that may have come from these emergency actions. In a sense, we’ve put the global economy on “steroids” — and we know there will be long-run consequences — but even more importantly, we know these “steroids” are creating distortions in our normal measures of global economic well-being.


The main page of the blog does not set off block quotes, which is kind of irritating. Doesn’t anyone at Reuters know how to design a weblog?

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The mild ‘W’ scenario

Sep 16, 2009 15:22 UTC

Yardeni sketches it out, though he thinks a “muddling along” is more likely:

1) Actually, the Petering Out scenario could start before yearend. Auto sales were clearly boosted during July by the Cash for Clunkers program. Congress expanded the program by an additional $2bn in August, and auto sales continued to rebound. Auto sales will probably weaken again unless it is renewed. Also, an $8,000 tax credit for first-time homebuyers will expire in November.

2) Furthermore, tax hikes are coming. The good news is that the Obama Administration hasn’t endorsed Charlie Rangel’s proposal to slap a big tax surcharge on high incomes as a way to pay for more government spending on health care. The bad news is that a massive tax increase is coming in 2011 after the Bush tax cuts expire next year. It is conceivable that consumers might cut back their spending in 2010 in anticipation of higher taxes.

3) Another concern is that the government will exit its various rescue programs prematurely. For example, last October, the FDIC provided temporary insurance guaranteeing the new debt of banks. Debt issued under the program is insured in some cases through June 30, 2012, and through December 31, 2012, in others. As of September 4, $304.1bn in debt was outstanding under the program. Ninety-four financial institutions have used it to issue debt.

4) The global economic recovery might also be at risk if Chinese authorities step on the brakes. During August, a few of them indicated that they are not happy to see that too much of bank lending has gone into real estate and stock market speculation. So they are leaning on the banks to lend less for such activities. Indeed, bank loans rose $60bn and $55bn during July and August, down from $181.5bn on average from January-June.

In conclusion, my sense is that a W-shaped economic pattern is widely expected. As the focus of investors extends beyond 2010, there are mounting concerns about the likelihood of the second recovery in this scenario, especially during 2011, if the Bush tax cuts are allowed to expire.

A phony recovery?

Jun 16, 2009 15:50 UTC

From former Morgan Stanley economist Andy Xie:

Contrary to all the market noise, there are no signs of a significant economic recovery. So-called green shoots in the global economy are mostly due to inventory cycles. Stimuli might juice up growth a bit in the second half 2009. Nothing, however, suggests a lasting recovery. Markets are trading on imagination. … The noise would be to emphasize the “temporary” nature of the stimulus. The market will probably be fooled again. It will fully wake up only in 2010. The United States has no way out but to print money. As a rational country, it will do what it has to, regardless of its rhetoric. This is why I expect a second dip for the global economy in 2010. … The world is setting up for a big crash, again. Since the last bubble burst, governments around the world have not been focusing on reforms. They are trying to pump a new bubble to solve existing problems. Before inflation appears, this strategy works. As inflation expectation rises, its effectiveness is threatened. When inflation appears in 2010, another crash will come.

Morgan Stanley: No V-shaped recovery

May 22, 2009 18:45 UTC

Economist Richard Berner lays out the case why the recovery won’t be a pretty sight:

First, financial conditions will stay relatively restrictive. Losses are still rising at lenders, limiting risk appetite and balance sheet capacity, and thus restraining the availability and boosting the cost of credit.  A slow cleaning up of lenders’ balance sheets will keep lending capacity low and the cost of using it comparatively high, and increased regulatory oversight will reinforce that restraint.  We think that such lingering restraint will affect all credit-sensitive areas of the economy, including housing, consumer durables, capital spending and working capital for businesses large and small.  As evidence, the National Federation of Independent Businesses just reported that, in April, credit was harder to obtain by small businesses than at any time in the past 29 years.  And while loan-to-value ratios at auto finance companies rose slightly in April – to 89% from 86% in January-February – required downpayments were still more than double what lenders wanted last year.

Moreover, the lags between the change in financial conditions and the economy will prevent rapid progress.  To be sure, as Morgan Stanley interest rate strategist Laurence Mutkin argues, when more capital comes into the financial system, and securitization revives, competition will erode the high rates lenders are able to charge for the use of their balance sheets today.   In our view, however, that time may be far off, and both the scars from the crisis and the regulatory response to it probably will keep those costs permanently higher than pre-crisis norms.

Second, the imbalance between supply and demand in housing is still significant and likely will remain a drag on home prices and housing activity into 2010.
The single-family vacancy rate in existing homes is double the 1.2% historical average through 2004.  Given the persistently tight financing backdrop, vacancies might undershoot that old 1.2% norm for a while to bring down the supply/demand imbalance quickly, especially as foreclosures rise again.  Consequently, prospective buyers need to start occupying roughly 750,000 single-family vacant homes before the housing market and home prices stabilize.  In turn, this implies that new and existing home sales must rise by roughly 20-25% from the current pace.  Likewise, in commercial real estate, vacancy rates and cap rates are rising and rents are falling.

Third, consumers have only begun the process of deleveraging and repairing their balance sheets and saving positions, and we believe that the personal saving rate, currently at 4%, will rise to 7-10% in the next few years. This process will mean slower growth in US demand.  Some argue that pent-up demand for vehicles and durables is strong following the recent retrenchment in sales.  We disagree.  It’s true that to maintain the stock of vehicles on the road (245 million light vehicles) given normal scrappage would require about 13 million vehicles sold annually.  But with financing constrained, we think that consumers can endure 3-4 years of sales below those levels, since we spent the last 13 above them, especially with 15% more light vehicles on the road than licensed drivers.

Finally, the breadth of the recession limits the cushion from any stronger sectors. For example, while growth appears to be improving in Asia, the global recession will limit US exports.  Unlike the experience since the crisis began nearly two years ago, in which net exports contributed more than a full percentage point on average to real US growth, we expect that the cyclical contribution to US growth from overseas activity will be flat to down over the next 18 months.