Growth Sector #1: Conundrums

Tuesday, June 07, 2005

Fed chairman Alan Greenspan's satellite transmitted remarks about the conundrum of rapidly flattening yield curves worldwide at the Chinese International Monetary Conference have added more certainty about the uncertain future of the global economy. Trying to find an explanation for the low long-term interest rates he offered the hypothesis, "that the markets are signaling economic weakness. This is certainly a credible notion. But periodic signs of buoyancy in some areas of the global economy have not arrested the fall in rates," only to partially withdraw in the Q&A session. Historically, an inverted yield curve was "a forward indicator for softening economic activity," Greenspan said and added, "I cannot tell you whether in fact we will see an inverted yield curve...I'm not sure what such a configuration, should it occur, would mean...I'm reasonably certain we would not automatically assume that it would mean what it meant in the past."
He also attributed the low rates - which he had called "fairly low" when they were about 40 basis points higher - at the long end to undiminished investor's demand for US debt and said this would not change soon. But this creates the unprecedented situation of a "pronounced decline in U.S. Treasury long-term interest rates over the past year, despite a 200-basis-point increase in our federal funds rate," he said. "I think the flow of funds is altered in such a dramatic way since the last time we saw that sort of inverted yield curve that I'd be doubtful to merely extrapolate (from historical data)", he said, effectively meaning that the past does not have to be a gauge for the future.
I'd be doubtful about that one as every recession is built on the same factors as there are:
  1. Too much cheap liquidity,
  2. too little necessary structural reforms and
  3. too much confidence that it won't happen again.

GRAPH: Inverted yield curves have preceded every recession (pink shaded areas) in the last 25 years.

Greenspan warned that lower bond yields are encouraging hedge funds and pension funds to take ever greater risks in an effort to boost investment returns but even as "the hedge fund industry could temporarily shrink", an euphemism for a shakeout ahead, "should not pose a threat to financial stability."
Recession not in central banker's official vocabulary
He warned that "the economic and financial world is changing in ways that we still do not fully comprehend. Policymakers accordingly cannot always count on an ability to anticipate potentially adverse developments sufficiently in advance to effectively address them. Thus our economies require, in my judgment, as high a degree of flexibility and resilience to unanticipated shocks as is feasible to achieve. Policymakers need to be able to rely more on the markets' self-adjusting process and less on officials' uncertain forecasting capabilities," which can be interpreted that the Fed itself does not know where the economy is heading to.
Given Greenspan's record this sounds a little implausible too.
Be reminded that NO central banker's official vocabulary contains the ugly nine-letter word "recession". The closest they come to it is "pain" or "crisis" or "adjustment period" and maybe now also "conundrum."
The market's reaction when the nine-letter word would come out of his mouth would certainly be a free fall, so this is an understandable no-no as all risk models are based on gradual price moves, an axiom questioned by Benoit Mandelbrot in this post.
Suspicious, though, is Greenspan's resistance to offer any insight into his own thoughts what might cause the conundrum in the yield curve. As he has offered quite a few explanations, always quoting other sources, his favourite one "market participants", this raises the question whether he has a private explanation, but cannot mention the nine-letter word for reasons stated above.
Maybe this quote of him on long-term rates should be understood as a warning. "Their nature and their behaviour is not something we are going to fully understand, if ever; certainly except in retrospect," he said of the new forces. That sounds dangerously reminiscent of bubble-talk.


Wikinvest Wire