The folly of more inversions, more recessions

 

With the whole yield curve now inverted (see below), and 2s-10s yield curve most inverted since 1980s,  the talk of inversions signaling recessions is growing louder and louder. This, to me, is simply baffling.

 

The case for linking inversions to recessions was always simple. Indeed, it is more of an observation connected with somewhat sound logic: Inversions occurred before all the recessions[1], and there is reason why inversions could be reflection of collective wisdom about coming decrease in interest rates below neutral due to coming recession (and hence signal of coming recessions).

That is all fine. Where I get lost is how does this apply to current inversions. For example, the 2s-10s inversion deepened significantly following the lower than expected US CPI report two weeks ago. This report led markets to (a) reprice the future path of federal funds, (b) correspondingly lower the 2-year yield, and also (c) lower the 10yr yield. Since (c) happened to a larger extent than (b), we ended up with deeper inversion.  On face of it, this might seem to somebody like bad news causing deeper inversion, right?

Do not count me in that camp. To see why, notice that the decrease in 10yr yield was different from the decrease in 2yr yield in that it mostly was not about lower expected path for fed funds rate.[2] Moreover, in so far as it was it was about expectations about future policy, it did not reflect expectations that policy rates will move eventually below neutral level, which is at the core of the signaling theory of yield curve inversion. Rather it reflected expectations that policy rates will rise less above neutral than was expected before. And if it was not about below neutral expected future rates, it is hard to argue that it was in some reflection of markets increasing their odds of recession, even though the inversion deepened significantly. If anything, it is hard to find anybody who thought the news were not good, as indicated by a positive stock market reaction. I am therefore struggling to follow the people who say that this development to them suggests risk of recession has increased.

Or take the most extreme example, the policy rate yield curve, which inverted only now. Is this in any way further strengthening of a signal of coming recession? Again, I struggle to see the argument. There are two reasons why the policy yield curve inverted now: the drop in 10yr yield, which I already argued was not a portend of coming recession; and increase in fed funds rates by the Fed during the November meeting. Of course, the increase in fed funds rate on its own can cause recession, but that is not the argument of yield curve believers. Rather, they argument is “Hey, it inverted, it must be a bad signal.” But if the inversion is caused by the central bank that increased fed funds rate, as expected, how can anybody interpret it as a signal of anything? Will it recession suddenly become much more likely on December 14, when policy yield curve will invert even more following the next hike, compared with December 13? I did not think so.[3]

So why are we having inversions if it is not because markets are pricing lower future rates because of recession? In other words, what do I say to somebody who might argue that long-term rates are always above short-term rates, unless markets expect policy rates to decrease, which is typically due to recession? Well, as you might guess, it is the typically, which is the problem. This inversion is not typical in that it is caused by the central bank itself. In other words, the central bank’s plan is for policy rates to follow an inverted “roof-shaped” path – rising significantly and temporarily above neutral before declining back to neutral.

This on its own should mean inversion, if bond yields are expected average future short-term interest rates (aka the expectations hypothesis). Therefore, the current inversions do not need to signal anything about the financial markets’ recessionary beliefs, just that they believe Fed’s intentions to go above neutral.[4] And this is what makes current inversion different from previous experiences: Back then, central bank was not hell-bent on going above neutral in fight against inflation, rather, it was trying to find neutral. And this, I think is an appropriate end to blog that has “folly” in its title: ending it with variation on the biggest folly of all, “this time is different”.

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[1] Of course, the statistician in me wants to scream something about N<10, but that is not the point for today.

[2] This is of course unsurprising, because changes in expectations about future rates rarely shift enough to move the 10yr yield, which is presumably the average expected value of fed funds rate over the whole 10yr horizon. Rather, the CPI report was catalyst for more broad repricing, which showed up as much lower real 10yr yield. Personally, I think it was in the spirit of coordination games a signal that this is finally the time when everybody will stop worrying that 10yr yield will rise further, and hence signal for everybody to buy 10yr yield, but that is purely speculation on my part.

[3] Similar argumentation applies to the 3m-10yr yield curve, even though there things are of course continuous.

[4] Note that the standard rules of logic apply – I am not saying markets are not expecting recession, or that recession will not happen, just that current inversions do not imply that markets are expecting one (even if they might be).  

The Swiss option for renumeration of excess reserves, reconsidered

 

When the Swiss central bank announced change to its renumeration of excess reserves held by commercial banks, I voiced skepticism that this would work. Specifically, I wrote that “when the system has large amount of excess reserves then this renumeration scheme should negate the increase in policy rates” and later that “one could address this by increasing the threshold [b]ut this would negate the desired goal of this policy which is decreasing the sums paid to commercial banks”.  Few months later, we know that the Swiss central bank did exactly what I said in the second part of the quote: it set the threshold above which excess reserves earn 0% interest to very high number – 28 times the required reserves. So while marginal excess reserves do pay 0% interest rate, the point where this marginal rate starts to apply is very high, so high that most (or no?) banks actually reach it.

In terms of the overnight market this means that there are banks that will borrow excess reserves at rates close but below the deposit rate, since they will be able to earn the deposit rate. In aggregate, the overnight (SARON) rate will stay close to the deposit rate, something we have indeed observed since the change (see picture below). The only difference is that the overnight rate is slightly below the deposit rate, rather than slightly above deposit rate, as was the case before the change. This reflects the fact that the banks lending reserves out now earn rate below deposit rate (0%), while borrowers earn deposit rate, so that the price of the transaction has to be in between those two. (Before lenders earned deposit rate, so the lower bound was the deposit rate; borrowers presumably would have to borrow at equivalent of marginal refinancing rate).

What about the effect on the payments from central bank to the commercial banks, which is presumably the main motivation? Of course, the policy means that for the 28-multiples of required reserves it is the deposit rate that applies, which means that the central bank is still paying large sums of money to commercial banks, despite the change it did. So, this policy should achieve very little in the direction of the desired outcome of lowering payments to commercial banks and corresponding losses for the central bank. That said, it does not achieve zero effect: as long as some banks are above the 28-multiple threshold, which is presumably the case, they are being paid less than what they would be paid otherwise.

So why did the Swiss central bank do it? It is hard to say. Partly, it might be simple theater for the public: setting the marginal rate for excess reserves to 0% means that the central bank can claim it did something. Equally, it might be issue of redistribution of excess reserves and profits: the change pushes excess reserves towards banks that are below the threshold and punishes banks with largest amount of excess reserves. What else? I think the evolution of ESTR, which stayed close to deposit rate despite it rising above 0%, makes it clear that the change can hardly be motivated by desire to impact the market interest rates, as the bank claimed; if anything, the move leads to slightly lower market interest rates.[1]

What does all this imply for the future behavior of the ECB? The fact that this is a lot about playing politics, rather than macroeconomic or financial policy, it is hard to know what the ECB will do. There are arguments for it not to do anything. First, it would avoid the whole messy business, including possible unintended consequences, perspective that might win given the limited effect on what it is supposed to achieve. Second, since it leads to lower overnight rate, and the magnitude of the effect might be hard to calibrate – especially in euro zone money market with much larger number of commercial banks and much bigger heterogeneity of excess reserves (see below).

 

 

 

That said, the ECB might still go for it despite the limitations. Apart from doing something for the sake of doing anything, even if the savings for the central bank would be small, the main motivation I could see is the positive effect on the redistribution of excess reserves: with potentially large costs of missed opportunity for banks above the threshold, there would be strong incentive for them to lend their reserves to banks below threshold. In environment of much higher overall interest rates this could have desirable financial stability effects. That said, since German banks would be hurt the most in terms of lost profits, the redistribution effects could also be a reason why this does not pass – the German central banker might not be too happy about this.

On balance, I now think that the ECB will stay clear of any change. It feels like that if they would do anything, they would have done it already when the changed the LTRO terms. The fact that back then they went for lowering the interest rate on required reserves – from main refinancing rate to deposit rate – but not for tiering suggests that they might have decided that going down this road offers too little benefit and too much risk. But of course, the ECB could easily surprise me once again.

 

 

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[1] Specifically, the bank said that it “ensures that the secured short-term Swiss franc money market rates remain close to the SNB policy rate”. True, they mention secured rates, which in euro zone are disconnected from the deposit rate, but that is mostly down to collateral shortage, and I don’t see how renumeration change affects that.