Friday, January 28, 2022

Yield Curve is Flattening

A little over two weeks ago, on January 11, I predicted the long end of the yield curve would come down, as the economy slows and the Fed commences its rate hike/QE unwind regime.

Since then, Jay Powell provided some hawkish commentary, and yesterday's GDP print came in red-hot at 6.9% for the fourth quarter of 2021, the highest quarter in forty years. Real GDP in 2021 grew 5.7% - the highest of my life by far. 

This should all be cause for celebration! The MMT crowd was write! America is back! Growth will be strong, rates will go higher!

And yet, as predicted, the 10yr/2yr spread has crashed from 85bp to 63bp, a decline of over 25%.

Not life-changing by any means, but it certainly happened faster than I anticipated.

I expect this curve flattening to continue, as the Treasury is removing dollars from the economy faster than it is replacing them. The Biden administration appears to unfortunately be listening to all the inflation hysteria in the press. Senators Joe Manchin and Kyrsten Sinema appear determined to throw the US economy into a recession, and guarantee the Democrats lose their majority in the House and the Senate in the midterms, and ultimately making Biden a one-term president, eliminating hopes for continued robust economic growth. That is not a partisan statement: the data is overwhelmingly clear that the US economy has grown faster over the last century with a Democrat as President. We don't have to be political about this, we just have to accept the reality that our economy will not grow as fast if more Republicans are elected, and prepare accordingly. For what it's worth, I am politically unaffiliated, and used to be a registered Republican.

Unfortunately, I expect this will lead to a recession, as we are starting to see with the yield curve flattening. The primary contributor to yesterday's big GDP figure was inventory builds. The political pressure to fight inflation has led to the government removing dollars from the economy. Retailers will be stuck with elevated levels of inventory, purchased at high prices thanks to the supply-chain problems, then sell them into an economy with fewer dollars to go around, forcing them to lower their prices. With FIFO accounting, that will depress earnings meaningfully (they get hit on both sides: higher unit costs with lower unit sales). 

Our elected officials, business leaders, journalists, and academics share the blame in this. They don't understand how our monetary system functions, so they insist on keeping dollars artificially scarce, using workers' livelihoods as a weapon to fight inflation. And while we can take advantage of this to make money in financial markets, their ignorance makes us all collectively poorer.

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