Tuesday, October 7, 2008

Current yield curve is off the IMF's charts

The International Monetary Fund (IMF) released its Global Financial Stability Report for October 2008. The first paraagraph reads:
“With financial markets worldwide facing growing turmoil, internationally coherent and decisive policy measures will be required to restore confidence in the global financial system. Failure to do so could usher in a period in which the ongoing deleveraging process becomes increasingly disorderly and costly for the real economy. In any case, the process of restoring an orderly system will be challenging, as a significant deleveraging is both necessary and inevitable. It is against this challenging and still evolving backdrop that the Global Financial Stability Report (GFSR) frames the recent events to suggest potential policy measures that could be helpful in the current circumstances.”
Point: Only international coordination will get us out of this mess. Further, it will be a painful process as firms and housholds delever.

Interesting Figure for today (Chart 3.6 in the report): Yield Curves and Business Cycles (Click to enlarge):
The chart illustrates the IMF’s estimated yield curve over the different phases of the business cycle: Trend, Trough, and Peak. It also lists the U.S. yield curve as of 10/03/08 and that at the defined trough of the last recession, 11/16/01. The 2001 recession better typifies a yield curve at the business cycle’s trough, however, the front end is slightly steeper.

On the other hand, the current yield curve doesn’t fit any of the historical patterns: Trend, Trough, or Peak (of course not peak). The steepness of the curve is not the problem, it is the relative magnitudes of the yields. The front end of the typical trough yield curve (1, 2, 3 yr maturities) yields 2.3 times the return relative to the current curve. The back end of the typical trough curve (10, 20, 30 yr maturities) yield 1.4 times the return relative to the current curve. In a banking crisis, the typical yield curve is all but a pipedream, as tight credit conditions prevail. Banks hoard short-term funds, resulting in a very low and steep front end of the curve.

We are in unchartered territory here. Only history books tell us how to avoid another Depression, since most of the people who survived it are no longer living. However, with the help of Economic Historians (Ben Bernanke) and intelligently coordinated efforts on the parts of all developed economies, we may just get through this thing.

Rebecca Wilder

1 comment:

  1. The Federal Reserve’s first fifteen years were a period of relative prosperity, but the crash of 1929 ushered in a decade of global financial instability and economic depression. Subsequent scholarship, notably the classic monetary history by Milton Friedman and Anna J. Schwartz (1963), argued that the Federal Reserve’s failure to stabilize the money supply was an important cause of the Great Depression. That view today commands considerable support among economists, although I note that the sources of the Federal Reserve’s policy errors during the Depression went much deeper than a failure to understand the role of money in the economy or the lack of reliable monetary statistics. Policymakers of the 1930s observed the correlates of the monetary contraction, such as deflation and bank failures. However, they questioned not only their own capacity to reverse those developments but also the desirability of doing so. Their hesitancy to act reflected the prevailing view that some purging of the excesses of the 1920s, painful though it might be, was both necessary and inevitable.


    Remarks by Chairman Ben S. Bernanke
    At the Fourth ECB Central Banking Conference, Frankfurt, Germany
    November 10, 2006

    Sounds familiar.

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