In the run-up to the Fed’s interest-rate-policy decision, inversion of the short-term “liquidity end” of the Treasury yield curve is a worrisome sign of a liquidity shortage in the financial system. With two-year Treasury-note yields trading slightly below the Fed’s overnight-policy rate, the appropriate policy response should be a more stimulative rate cut of at least 50 basis points and probably 75, not the 25- to 50-basis-point range under discussion by market commentators.
Over the past ten prosperous years the funds rate typically traded about 50 bps below the two-year note, indicating sufficient high-powered liquidity to meet the demands of economic growth. Between early 1991 and late 1993, as the Fed labored to promote recovery from the credit-crunch recession that lingered on after the Persian Gulf War, the funds rate generally traded about 100 basis points below the two-year note.
From early 1996 to mid-1997, as the Fed fought the headwinds of global deflation (and a slumping gold price), the funds rate averaged 75 basis points below the two-year note. Now, however, the funds rate is above the two-year note. In the recession-prone economy, this is a mistake.
When the liquidity end of the Treasury curve is positively sloped, with the rate on overnight fed funds properly below the two-year Treasury, then banks are encouraged to supply credit to the economy through investment purchases of Treasury notes. The “positive carry” of a normal yield curve allows banks to borrow cheap from the funds market in order to profitably finance the higher-yielding two-year note. When banks purchase Treasury securities from broker-dealers, they pay with cash. This cash infusion helps to reliquify the economy.
Since the last Fed meeting on May 15, gold and other inflation-sensitive commodity indicators remain below their long-term moving averages. Energy costs are plunging. King dollar is strong. Inflation-forecasting TIPS spreads have narrowed. Corporate credit spreads have widened. Ten-year Treasuries have descended below 5.2%. Recent investment behavior to sell stocks in order to purchase risk-free Treasuries is surely a “recession trade.”
In order to reformulate an appropriately pro-recovery, upward-sloping liquidity curve, the Fed should at least drop its overnight policy rate to 3½%. A 75 basis-point move to 3¼% would be optimal. The sooner the better.
Then end the easing cycle. Economic activists would stop waiting for the interest-rate bottom, and no longer postpone investment-financing decisions. All that cash laying fallow in money-market funds could be put to work. Along with the tax-cut effect of falling energy costs, a cycle-ending 75 basis-point cut could ignite economic recovery sooner than the forecasting consensus expects.
Late last week the National Bureau of Economic Research, America’s official business-cycle arbiter, posted a website note that “data normally considered by the committee indicated the possibility [italics mine] that a recession began recently.” That’s a newly pessimistic economic assessment from the sober-minded NBER fact-finders. Greenspan & Co., please take note. It’s time to be bold.