The Breakdown - Central Banks Sending Worrisome Signals About the Economy

Episode Date: November 6, 2021

This episode is sponsored by NYDIG. On today’s episode, NLW gets macro with a discussion of a flattening of the yield curve and what increasingly seems like a failed yield curve control experiment in Australia. He looks at: What the “yield curve” is What a yield curve flattening or inversion is signaling The latest from the U.S. Federal Reserve on tapering  Australia’s yield curve control problem  NYDIG, the institutional-grade platform for bitcoin, is making it possible for thousands of banks who have trusted relationships with hundreds of millions of customers, to offer Bitcoin. Learn more at NYDIG.com/NLW. Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Join the discussion: https://discord.gg/VrKRrfKCz8   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell, research by Scott Hill and additional production support by Eleanor Pahl. Adam B. Levine is our executive producer and our theme music is “Countdown” by Neon Beach. The music you heard today behind our sponsor is “Dark Crazed Cap” by Isaac Joel. Image credit: Nuthawut Somsuk/iStock/Getty Images Plus, modified by CoinDesk.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by Nidig and produced and distributed by CoinDesk. What's going on, guys? It is Friday, November 5th, and today we are talking about what central banks are telling us about the economy. You might have read on Bloomberg or the Financial Times or something like that that investors are noticing a flattening of the yield curve. Now, to discuss what that means, we should probably start by asking WTF is the yield curve. So glad you asked. The yield curve is a plot of all of the interest rates of sovereign bonds based on their maturation. For example, the U.S. Treasury market is a nearly

$15 trillion market. It includes T-bills that have one month to one-year maturity, two years to 10 years, as well as 20 and 30 years. And in general, you would expect the yield curve to slope upwards. In other words, bonds with longer maturity would have a higher yield. This makes sense because investors would expect more compensation for having a longer maturation period. A longer maturation period means more risk, more expectation of inflation. In other words, 10-year notes should have a higher yield, ceteris paribus, than two-year notes. So what does it mean when the yield curve flattens or inverts. Well, of course, it means that short-term bonds have a similar or even higher yield than longer-dated bonds. It means there is more demand for those short-term bonds, and often

this presages recessions or other market turmoil. So what is the explanation for why this is happening now? Well, in the U.S., it has to do with Fed policy. The Fed announced earlier this week that they are going ahead with their taper of the $120 billion bond buying program that has been in place since the beginning of the COVID crisis. This taper has been super, super clearly telegraphed to investors, but many think that inflation will in fact force their hand faster, compelling them to more quickly unwind bond buying and even getting into interest rate hikes earlier than they say they want to. At the same time, in the U.S., long-term bond yields have fallen. And effectively, this is explained by people believing that this forthcoming hawkish monetary policy, a policy they believe is inevitable,

will be successful in bringing down inflation. However, it's not just the U.S. This sort of yield curve flattening and inversion is happening all around the world. Australia, Germany, Canada, basically anywhere investors are expecting central banks to have to move to tighten policy faster than those policymakers would have ideally liked to. But here's where everything gets tricky. What do central banks normally do when the yield curve inverts signaling a recession? They lower benchmark interest rates, which has the tendency to lower the front and end of the yield curve. In other words, writing that flattening or inversion. However, in today's environment, basically every central bank is already at the zero bound of interest rates. And while

theoretically, they could lower them to nominally negative rates, the experience of the European Central Bank has suggested that dipping into negative rates hasn't done much to spur investment in growth. So this is a real rock and a hard place situation. On the one hand, almost everywhere we're seeing two to seven percent annualized inflation, and that would lead central banks to want to raise rates to fight that inflation. But there is risk with raising rates. Those rates might trigger a recession, a recession that the yield curve is already telegraphing. So do they go the other way, trying to lower rates and do more QE to write the curve? But what happens if that just exacerbates inflation? What we're seeing is effectively what happens when you have no more road to

kick the can down. So with all of this background, let's do a little survey of what some of the central banks around the world are actually doing. In the U.S., as I mentioned, the Fed has been prepping markets for a taper for months. At the FOMC meeting this week, they confirmed it. They will start to slow bond purchases at a pace that would see them completely out of the game by mid next year. However, they are not currently entertaining interest rate increases and doubling down, in fact, on needing to see more improvement in labor markets first. Jerome Powell said, we have high inflation and we have to balance that with what's going on in the employment market. It's a complicated situation. We don't think it's a good time to raise interest rates because

we want to see the labor market heal further. The level of inflation we have right now is not at all consistent with price stability. Basically, Powell is shrugging and saying, we don't know what to do. In fact, he even suggested that this time calls for humility. That was his word. NIDIG, the sponsor of this podcast, provides banks, corporate treasuries, pensions, and hedge funds with ironclad Bitcoin custody and white glove service. Learn more at NIDIG.com slash NLW. That's nydig.com NLW. Let's pop over to Australia now, and one of the things that made their approach different during the COVID crisis was that they went to full yield curve control. This is different than the policies that the U.S. implemented, so to understand what yield curve control is, here's a simple description

from Sage Bells and David Wessel at Brookings. QE, or quantitative easing, deals in quantities of bonds. Yield curve control, or YCCC, focuses on prices of bonds. Now, this is a super important concept, so I'm actually going to repeat it again, and then I'll keep reading this explanation. QE deals in quantities of bonds. YCC focuses on prices of bonds. Under QE, a central bank might announce that it plans to purchase, for instance, $1 trillion in Treasury securities. Because bond prices are inversely related to their yields, buying bonds and pushing up their price leads to lower longer-term rates. Under YCC, the central bank commits to buy whatever amount of bonds the market wants to supply at its target price. Once bond markets internalize the central bank's

commitment, the target price becomes the market price. Who would be willing to sell the bond to a private investor for less than they could get by selling to the Fed? So, the Royal Bank of Australia went the YCC road. And to describe what happened next, I'm actually just going to quote Scott Hill, who is the new overnight researcher for the breakdown, because in his notes for this episode, he just put it so succinctly. He writes, the RBA targeted specifically the April 24 issuance of bond. which at the time was a three-year expiry bond. This was due to the Australian government's stimulus response being partially focused on encouraging housing purchases, with several programs aimed at the housing sector. In Australia, the most common fixed-rate mortgage term on offer

is three years. So by targeting the three-year bond, the RBA sought to subsidize mortgage rates for new and refinanced loans. Another leg of this policy was the term funding facility, a three-year funding vehicle for authorized deposit-taking facilities, i.e. commercial banks, intended to allow for certainty in the funding rates that the banks could offer three-year fixed mortgage loans on. These policies, together with significant increases in housing loans being committed to, since the beginning of the coronavirus, sets up the Australian economy to have a rate cliff in 2024, similar to the subprime issues in the U.S. where a significant cohort of the population will have to refinance throughout 2024 from subsidized low rates to whatever the prevailing rate at the time is.

So now we are seeing a lot of cracks in this policy in Australia. Here's a sample of headlines. RBA waves white flag on bond yield target so interest rates may rise sooner than expected. RBA may be forced to raise interest rates despite 2024 promise. ASX and Australian dollars slip after Reserve Bank hints at faster rate hikes. There is a ton of commentary on this on Twitter, basically a ton of people calling it an abortive experiment. And while a lot of this is very technical and sort of macro-wankery, there are some real implications for human beings that have to live in the world and with the consequences of these actions. Scott, again, puts it nicely.

Quote, this wasn't just open market policy. This was an explicit promise to the Australian people that the RBA had their back to go and buy a house at inflated prices with the cover of subsidized interest rates. The promise was the centerpiece of government stimulus policy. The government encouraged people, especially younger, first-time homebuyers, to go and purchase their first property into a hot market. By way of the most extreme example, Sydney's median house price increased by 30% on an annualized basis to reach 1.5 million on most recent data.

If housing prices fall by 20%, that will be the biggest loss of credibility for Australian institutions that I can think of. It will fall mostly on the young that were induced by stimulus packages to purchase into a hot market in 2020. In short, there is a short-term implication in terms of homebuyers who might be underwater, end quote.

So, in short, just to sum up, there are short-term implications in terms of homebuyers who might find themselves underwater, in terms of banks that are leveraged to housing, and of course to the credibility of the central bank and the YCC experiment in general. And by the way, the rest of the world isn't looking great right now either. South Korea is seeing its highest inflation since 2012, while Q3 GDP grew at a slower pace and missed its forecasts, aka stagflation.

The European Central Bank is trying to hold the line, but warning of more inflation, the Bank of England is planning on raising rates, and the Swiss are having the inverse problem. Because they are considered such a safe haven, their currency is strengthening too much, which is threatening employment. So to sum this all up, I go back to that kicking the can down the road analogy. We seem to be in some ways just running out of road to kick the can down. And the real thing to keep an eye on here aren't the specifics of policy

but about central banks losing credibility and losing influence and running out of tools. Their influence especially is every bit as much a part of monetary policy as the policy itself. Much of the work of central bankers, it is clear, is in signaling where they go next so the market adapts even before they've made the change. Not to end on too aggressive a buy-bikcoin note, but you've got to think, if the credibility of central banks continues to go down around the world, where do you think that unconvinced skeptical capital is going to flow? Until tomorrow, guys, be safe and take care of each other. Peace.