If The Fed Doesn't Restart QE, A Yield Curve Inversion (& Economic Dislocation) Is Imminent

Submitted by Chris Hamilton via Econimica blog,

Once upon a time, banks were about lending money and banks business model depended upon the spread or difference of borrowing short and lending long.  The greater the differential in the spread of short term and long term lending, the greater the profit.  So, it should be noteworthy when the spread begins shrinking.  At present, spreads have fallen 65-75% from 2011 peaks…and are rapidly gaining speed to the downside.  The chart below shows the spreads based on the 30yr and 10yr Treasury’s minus the 2yr.

The chart below shows the 10yr Treasury yield since 2008, with the onset of Quantitative Easing.  During each period of Federal Reserve buying (QE), rates rose and the spread (10yr minus 2yr) likewise rose (yellow line).  During each period when QE ceased or was tapering, yields fell and likewise the spread fell.  Since the announcement of the QE3 taper, the 10yr and spread have been collapsing.
It was only the announcement of QE3 (QE-infinity…see yellow pointer in chart below) that effectively ceased the 10yr and spread declines that were well underway during Operation Twist.  As the Wu-Xia shadow rate implicates, rates were effectively driven well below zero due to QE.  However, as the chart below highlights, since the announcement of the QE3 taper, rates and spreads have resumed their downward course.  A rate inversion (and the economic dislocation that comes with it) is imminent like winter following fall and trees currently growing to the sky with nary a root (see Russell 3000…black line) will tumble.

Given the recent Fed Funds rate hike only accelerated the spread collapse; if the Federal Reserve does not change course and re-implement QE in short order, the rate inversion and subsequent economic dislocation is just a matter of time.  So, what is the Fed talking about regarding raising rates & what game is the Fed playing?  QE was never a cure but simply a means to extend and pretend just a bit longer.  Could it be the pretending and extending have hit some sort of limit and the Fed fears the next Fed administered “cure” may kill the patient?


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Author: Tyler Durden

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