Wednesday, February 9, 2022

Yield Curve Is (Still) Flattening, Liquidity Is Evaporating

There was a lot of excitement late last week about the BLS report showing US nonfarm payrolls added 467,000 jobs in January, and revising the prior period up by nearly 200,000, handily beating expectations.

While it's worth noting that there were some revisions to prior-reported data as part of its annual review, this is undoubtedly good news about the health of the economy and further supports the fiscal stimulus measures enacted by Congress in 2020 and 2021.

Per the WSJ, the report caused stocks to rise and bonds to fall.

(Side note - I have always been skeptical when I read or hear in the news about some presumed cause/effect relationship with regards to that day's news and the price action in financial markets. In the real world, investment decisions are frequently made days, weeks, even months in advance and are completely unrelated to what the mainstream media is reporting. Frustrating, but that is the world we live in.)

And while it's true that bonds largely sold off on Friday, what's more important is that the 2yr/10yr spread continued to fall, reaching its lowest level since October 2020. Per Bloomberg:

The fact that this is happening is an indication that monetary conditions are too tight. Interest rates are the price of credit money. Like any other commodity, money gets priced on a curve, at the intersection of supply and demand, over a period of time. New money supply is added through two channels: commercial bank loans and fiscal spending. As time passes, money is constantly being created and destroyed: money is created when banks make loans or the government injects new money, and it is destroyed as loans and taxes are paid off. Bank lending is primarily driven off of income: a loan is made if the lender believes the borrower has capacity to service its debt given their income. If long-term rates are falling relative to shorter term rates, that is an indication that demand for long-term borrowing is weak, forcing lenders to lower their rates. Perhaps people don't feel confident about their future income prospects, so they hold off on making long-term purchases like homes and autos. When this happens, banks are forced to lower rates (prices) in order to encourage people to borrow and spend.

Likewise, rising short-term rates indicate that current demand for money is on the rise, hence the price is going up. A flattening yield curve is therefore a signal that there are too few dollars in the economy: near-term demand for dollars is rising at the expense of future dollars. 

Without a surge in bank lending (which requires people to feel confident about their capacity to service debt with incomes earned) or fiscal spending (which requires cumbersome political processes), the supply of dollars across the time continuum is somewhat fixed. People need cash now, and they have limited access to cash in the future (for myriad reasons) so they borrow short-term, which leaves fewer dollars leftover for future spending. Given spending = income in aggregate, lower future spending means lower future income.

Per the aforementioned BLS report, the labor force participation rate (62.2%) and employment-population ratio (59.7%) remain below February 2020 levels, which were themselves unimpressive after declining for two decades. Fewer people working is a drag on the economy, limiting its full productive capacity and therefore suppressing incomes available for workers. Limited income for workers means fewer people feel comfortable taking out a long-term loan.

The government could fix this with a Job Guarantee. I also firmly believe that a student debt relief program would create new capacity for borrowers, and jumpstart the economy. Without these kinds of programs (or some other stimulus), however, I expect the curve to keep flattening as we head closer to recession.

There are already signs that economic growth is slowing. PayPal (PYPL) provided weak guidance on its earnings call last week, sending the stock down 24% in a day, citing a slowdown in consumer spending, particularly among low-income earners. They cited Omicron, inflation, and the lack of fiscal stimulus as contributing factors.

Likewise, mortgage loan servicer loanDepot (LDI) indicated on a recent earnings call that cash-out refi's were going to be much lower in 2022 than in 2020. Cash-out refi's are an important source of liquidity for consumers, and a slowdown there suggests that liquidity will tighten - consistent with earlier points about tighter monetary conditions. With fewer dollars to go around, sales and incomes should stagnate.

If there was ever a sign of tightening liquidity, consider that Meta Platforms (FB, formerly Facebook) recorded the largest market cap loss ever last week at $232 billion after a terrible earnings print. Meanwhile, Snap Inc. (SNAP) shot up nearly 60% after hours last week, adding around $23 billion to its market cap. The fact that megacap tech companies are suddenly trading like penny stocks is a sign of a lack of liquidity in the markets. Expect more volatility ahead.

And who can be expected to be a beneficiary of this volatility? I'll save that for a future post. Hint: It was one of the companies included in my Financials model portfolio posted on earlier this year.

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