Diary

Kudlow Misses an Important Point

in his latest column

Kudlow writes

What’s a yield curve and why is it so important?

Well, the curve itself measures Treasury interest rates, by maturity, from 91-day T-bills all the way out to 30-year bonds. It’s the difference between the long rates and the short rates that tells a key story about the future of the economy.

When the curve is wide and upward sloping, as it is today, it tells us that the economic future is good. When the curve is upside down, or inverted, with short rates above long rates, it tells us that something is amiss — such as a credit crunch and a recession.

The inverted curve is abnormal, the positive curve is normal. We have returned to normalcy, and then some. Right now, the difference between long and short Treasury rates is as wide as any time in history. With the Fed pumping in all that money and anchoring the short rate at zero, investors are now charging the Treasury a higher interest rate for buying its bonds. That’s as it should be. The time preference of money simply means that the investor will hold Treasury bonds for a longer period of time, but he or she is going to charge a higher rate. That is a normal risk profile.

The yield curve may be the best single forecasting predictor there is. When it was inverted or flat for most of 2006, 2007, and the early part of 2008, it correctly predicted big trouble ahead. Right now it is forecasting a much stronger economy in 2010 than most people think possible.

Kudlow chooses his words imprecisely when he states “When the curve is wide and upward sloping, as it is today, it tells us that the economic future is good”. No, what that signals is that the market expects future interest rates to be higher. Which usually foretells an increased demand for money (a good future economy) to be the driving factor.

But these aren’t usual times, and Kudlow’s article doesn’t address the supply side. This year, the Fed took the (cough) unprecendented step of buying US Treasurys with fiat money at Treasury auctions. Until this year, US Treasurys–the legal right to be paid in dollars from future government (tax) revenues–were auctioned in the free market. If the US government needed $50 billion, it would take bids on yields, and following the auction, the lowest $50 billion bids were issued a Treasury at the rate bid by the last ($50 billionth) bidder.

For the first time, this year the Fed stepped in to suppress/manipulate yields. Rather than allowing the free market to fill the $100+ billion monthly auctions, the Fed stepped in to cap yields by “printing money” to artificially fill the last portions of those auctions at an artificially low interest rate. By creating extra claims (dollars), one would usually expect the value of a single dollar to decline, i.e., one would expect inflation. (And in fact, the value of the dollar as a claim on world wealth has decreased via currency exchange rates.) But at the end of 2009, the chasing of goods with dollars is slow, and banks are hesitant to lend, so inflation (in US dollars) has yet to hit.

But at some point, the extra dollars will start chasing goods at closer to normal vigor. At this time, Bernanke will have two choices: 1) leave the extra money out there, leading to inflation, and higher rates. (I don’t expect him to follow this path, because it permanently would discredit the dollar.) Or 2), take back all the money the Fed bought by fiat via US Treasury auctions above and beyond those normally scheduled. For example, if the Treasury needed to auction off $150 billion monthly to finance an annual $1.8 Trillion deficit, it would instead auction off, say $175 billion to reclaim some of that formerly “printed” money. And the rate required to attract $175 billion versus $150 billion? Higher.

And this is why I am discounting Kudlow’s reading of the yield curve as a predictor of “strong growth” ahead.