The Risks of Upward Jumps and Twists of the ˩-shaped Yield Curve
Carlos M Pelaez

On Jan 5, 2005, the percentage yields per year of Treasury securities were: 3-months 2.33, 2-years 3.22, 5-years 3.73, 10-years 4.29 and 20-years 4.88. The difference between the 10-year note and the 3-month bill was 89 basis points. The yield curve had the upward slope typical of expansions after six months of 25 basis points increases in the target of fed funds by the Federal Open Market Committee (FOMC). On Jan 5, 2010, the percentage yields per year of Treasury securities were: 3-months 0.15, 2-years 0.91, 5-years 2.35, 10-years 3.69 and 30-years 4.64 (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml ). The yield curve has a sort of J shape with a near horizontal segment up to one year and then a positively sloped segment. The difference between the 10-year note and the 3-month bill is 354 basis points. The risk of future jumps and twists of the J-shaped yield curve is one of the most important aspects of monetary policy and perhaps even of the rate of growth of the economy and employment creation. The sections below analyze the origins in monetary policy of the J-shaped yield curve and its relation to the government deficit and debt and proposals for financial regulation.
I. Origins. There are three factors explaining the J-shaped yield curve. First, the Fed has lowered interest rates close to the “zero bound” in two occasions. Central banks have been aggressive in monetary policy because of the “great moderation,” or reduction in the volatility of output and inflation beginning in the 1980s and ending with the current crisis (Kenneth Rogoff cited in Pelaez and Pelaez, Regulation of Banks and Finance, 221, Globalization and the State, Vol. II, 195). Of three competing explanations, (1) structural change of the economy permitting absorption of shocks such as the oil price increases of the 1970s and 1980s, (2) macroeconomic policy and (3) luck in the form of less frequent shocks, (2) macroeconomic policy in the form of sound monetary policy may have been important in ensuring stable growth (http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2004/20040220/default.htm#fn1 ). The process of inflation targeting appeared to have provided a new paradigm for the conduct of monetary policy ensuring sustained growth of output with price stability (Pelaez and Pelaez, Regulation of Banks and Finance, 108-112, Financial Regulation after the Global Recession, 74, 84-6, International Financial Architecture, 230-7). The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the Federal Open Market Committee from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change.
Second, the traditional tool of reducing rates was complemented by the creation of about 11 credit facilities by the Fed (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). Abundant credit may have played a role in maintaining rates around zero in the short-dated segment of the yield curve.
Third, the Fed engaged in the policy of quantitative easing (Pelaez and Pelaez, Regulation of Banks and Finance, 224, The Global Recession Risk, 83-107). When the policy rate or fed funds rate is near the “zero bound” the Fed could expand its balance sheet by acquiring government securities, ignoring the interest rate and focusing on the volume of bank reserves (http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm ). The purchase of long-term securities by the Fed could lower long-term interest rates, stimulating recovery of the economy by increasing investment. The Fed borrowed from banks by paying interest rates on excess reserves deposited by banks at the Fed and from Treasury by depositing the proceeds from the issue of short-term Treasury bills at the supplementary account of the Fed; these deposits were invested by the Fed in long-term Treasury securities, agency debt securities and MBS. The Fed balance sheet increased by 115.7 percent from $855.1 billion in February 2008 to $1844.9 billion in February 2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The Fed balance sheet for the week ending Mar 3, 2010, lists holdings of $1026 billion of MBS, $708 billion of Treasury notes and bonds and $167 billion of Federal agency securities with $1198 billion of reserve balances deposited at the Fed and now $25 billion in the supplementary financing account that will grow to $200 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). At some point the Fed would sell that portfolio of about $1.8 trillion of long-term securities, causing a decrease in their prices that is equivalent to an increase in their yields. Thus, there is potential pressure on long-term interest rates by the Fed portfolio of securities.
II. Government Deficit. The Congressional Budget Office has provided preliminary analysis of the budget deficit for the next ten years that suggests pressure on US financing needs and thus rising yields of Treasury securities (http://cboblog.cbo.gov/?p=482 ). The federal government deficit in 2010 would reach $1.5 trillion or 10.3 percent of GDP and $1.3 trillion in 2011 or 8.9 percent of GDP after a deficit of 9.9 percent of GDP in 2009. The cumulative deficit between 2011 and 2020 would be $9.8 trillion. The federal debt held by the public would increase from $7.5 trillion in 2009 or 53 percent of GDP to $20.3 trillion or 90 percent of GDP. Net interest paid on the debt would quadruple, increasing from 1.4 percent of GDP in 2010 to 4.1 percent of GDP in 2020. Tax increases and rising interest rates resulting from these prodigal budgets will likely flatten the growth path of the economy and job creation, triggering more aggressive revenue and expenditure measures to avoid the projected deficits and debt levels. In the short term, knowledge of this tight fiscal situation will set pressure on all segments of the yield curve. Increases in interest rates of Treasury notes and bonds are equivalent to declines in their prices. The expectation of capital losses and the worsening fiscal situation will cause increases in the required yield of securities demanded by investors.
III. Regulatory Shock. A fragile jobless recovery is inopportune timing for regulatory shocks and attacks on financial institutions and the Fed’s regulatory/supervisory authority. The administration announced on January 14, 2010, the creation of the Financial Crisis Responsibility Fee or the Tax on Big Banks (http://www.whitehouse.gov/the-press-office/president-obama-proposes-financial-crisis-responsibility-fee-recoup-every-last-penn ). The tax is fifteen basis points of covered liabilities per year or: (0.0015) x covered liabilities. These covered liabilities are defined as assets less Tier 1 capital less FDIC-assessed deposits (and/or insurance policy reserves, as appropriate). Tier 1 capital as defined in the Basel Capital Accord, also applied to Basel II, is being reformulated in the current consultative document of the Basel Committee on Banking Supervision (BCBS) (http://www.bis.org/publ/bcbs164.pdf?noframes=1, 4) as consisting mainly of retained earnings and common shares. The remaining portion of Tier 1 capital must consist of subordinated instruments with dividends or coupons that are non-cumulative without maturity date or incentive of redemption (for soft law and the Basel accords see Pelaez and Pelaez, International Financial Architecture, 239-300, Globalization and the State Vol. II, 114-48, Government Intervention in Globalization, 145-50, Financial Regulation after the Global Recession, 54-6, Regulation of Banks and Finance, 69-70). The BCBS is calibrating the overall minimum capital ratio and the composition of Tier 1 capital as part of the impact assessment process. Retained earnings and common shares will remain as the major portion of Tier 1 capital. The assessment of the Federal Deposit Insurance Corporation (FDIC) is a fee paid by insured depository institutions on their insured deposits (http://www.fdic.gov/regulations/laws/rules/2000-5000.html#fdic2000part327.3 See Pelaez and Pelaez, Regulation of Banks and Finance, 71-8, Financial Regulation after the Global Recession, 56-8). Consider the administration’s example of a bank with $1 trillion assets, $100 billion in Tier 1 capital and $500 billion in assessed deposits. The yearly tax would be: 0.0015 x ($1000 billion - $100 billion - $500 billion) = 0.0015 x $400 billion = $600 million. This tax will be assessed only on banks with more than $50 billion in assets and the administration expects that 60 percent of the tax will be collected from the largest ten banks. The objective of the tax is collecting over time the expected net cost of the Troubled Asset Relief Program (TARP) of $117 billion. The expected revenue from the tax in the first ten years would be $90 billion so that in about 12 years the government would recover the loss from TARP. The rationale of the tax is that the largest banks that received (and repaid with interest and repurchase of warrants) capital injection from TARP benefited directly or because of improved financial markets and should pay for the losses of other TARP recipients such as car manufacturers, Fannie Mae, Freddie Mac and AIG. The CBO finds that “the costs of the proposed fee would ultimately be borne to varying degrees by an institution’s customers, employees and investors, but the precise incidence among those groups is uncertain” (http://cboblog.cbo.gov/?p=479 ). An earlier post of this blog argues that the tax would likely be borne mostly by customers because of the inelasticity of demand for credit and the current difficulty of consumers in finding credit in part because of the regulatory shock. The bank fee, Volcker rule, restriction on the size of banks, the consumer protection agency and so on are inopportune measures at the moment that only have adverse effects on the growth of the volume of financial intermediation required to finance strong and sustained economic growth motivating dynamic job creation. The general public pays for these measures in the form of higher interest rates and lower volumes of available credit as shown by the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and subsequently by lower growth and employment creation.
The first week of March, as typical, is full of important economic reports. The short-term indicators provide more evidence of the “nascent” economic recovery. The two reports of the Institute for Supply Management (ISM) are encouraging (http://www.ism.ws/ ). While the ISM manufacturing index declined from 58.4 in Jan to 56.5 in Feb, the level is high, pointing to growth. Employment increased from 53.3 in Jan to 56.1 in Feb. The nonmanufacturing index jumped from the borderline level of 50.5 in Jan to 53.0 in Feb and employment increased from 44.6 in Jan to 48.6 in Feb but still remains at a low level. Construction spending declined 0.6 percent in Jan relative to a revised value in Dec and is still 9.3 percent below the level in Jan 2009 (http://www.census.gov/const/C30/release.pdf ). New orders for manufactured durable goods increased by 1.7 percent in Jan, 0.1 percent when excluding transportation and 1.0 percent excluding defense. New orders for all manufacturing increased by 8.8 percent relative to the level in 2009 and by 7.9 percent excluding defense or transportation (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). Nonfarm payroll employment declined by 36,000 in Feb and the unemployment rate remained at 9.7 percent with an unchanged 14.9 unemployed persons (http://www.bls.gov/news.release/pdf/empsit.pdf ). The number of involuntary part-time workers who cannot find other type of employment increased from 8.3 to 8.8 million. An important aspect of the employment situation is that 4 in 10 unemployed persons have remained unemployed for 27 weeks or more. Unemployed workers seldom return to the same jobs lost in the recession because they do not exist. New job creation will require a highly dynamic economy and incentives for private-sector creation of new jobs. The index of pending home sales of the National Association of Realtors (NAR) declined in Jan by 7.6 percent relative to an upwardly revised level in Dec but it stands 12.3 percent above the level in Jan 2009 (http://www.realtor.org/press_room/news_releases/2010/03/phs_down ).
Short-term indicators and the Fed’s Beige Book (http://www.federalreserve.gov/fomc/beigebook/2010/20100303/default.htm ) support the view of “a nascent economic recovery” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). Policy can create incentives for acceleration of the recovery by avoiding deficits, debt and regulatory shocks that could exacerbate upward jumps and twists of the J-shaped yield curve. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)