Treasury Yield Curves (Measure of Market Traders’ Y/Y and P/P Expectations) Web address: http://www.federalreserve.gov/releases/h15/ No revisions, instant data from bond markets Reflects the collective wisdom on the likely direction of the economy (Y/Y) and inflation (P/P). Expectations of future economic growth and inflation determine which Treasury debt securities are the most attractive to buy. The yield curve shape is a powerful forecasting tool. Federal Reserve sets short-term yields by targeting the fed funds interest rate. Bond traders determine longer-term yields. Normal Yield Curve Shape: Lower short-term yields with yields gradually rising with bond maturity. (longer maturities face greater unknown risks – war, politics, P/P - and hence require higher returns). The 3-month versus 30-year spread is about 2.5 percentage points with a normal yield curve. Steep Yield Curve Shape: Federal Reserve lowers short term rates to counter recession or inflation fears induce bond traders to sell long-term bonds. The 3-month versus 30-year spread is greater than 2.5 percentage points. Flat Yield Curve Shape: The economy is in danger of slipping into recession resulting in lower inflation. Bond traders buy long-term bonds to lock in higher long term yields => long-term yields fall relative to short-term yields. Probability of recession is 50% according to a Federal Reserve study. Inverted Yield Curve Shape: Short-term yields higher than long-term yields. Siren call that a recession is coming. The bond market believes the Federal Reserve is keeping monetary policy to tight and money supply growth to low. The last seven recessions have been preceded by an inverted yield curve 9 months – on average - in advance. If yield inversion is greater than 2.4 percentage points, then probability of recession is 90% in the next 18 months. ------------------------------------------------------------------------------------------------------------------------------------- ----------- Market Analysis: Bonds: Yield curve represents bond market Stocks: Stock prices are based on expectations of future profits and economic activity, so the yield curve can serve as an effective market-timing strategy tool Dollar: Inverted Y.C. may reduce foreign investor appetite for U.S. assets if believe recession is coming => $. However, an inverted Y.C. may attract “hot money” into U.S. investments if short-term U.S. interest rates are significantly above overseas short-term interest rates => $
Transcript
Treasury Yield Curves(Measure of Market Traders’ Y/Y and P/P Expectations)
Web address: http://www.federalreserve.gov/releases/h15/No revisions, instant data from bond markets
Reflects the collective wisdom on the likely direction of the economy (Y/Y) and inflation (P/P). Expectations of future economic growth and inflation determine which Treasury debt securities are the most attractive to buy. The yield curve shape is a powerful forecasting tool.
Federal Reserve sets short-term yields by targeting the fed funds interest rate.Bond traders determine longer-term yields.
Normal Yield Curve Shape: Lower short-term yields with yields gradually rising with bond maturity. (longer maturities face greater unknown risks – war, politics, P/P - and hence require higher returns). The 3-month versus 30-year spread is about 2.5 percentage points with a normal yield curve.
Steep Yield Curve Shape: Federal Reserve lowers short term rates to counter recession or inflation fears induce bond traders to sell long-term bonds. The 3-month versus 30-year spread is greater than 2.5 percentage points.
Flat Yield Curve Shape: The economy is in danger of slipping into recession resulting in lower inflation. Bond traders buy long-term bonds to lock in higher long term yields => long-term yields fall relative to short-term yields. Probability of recession is 50% according to a Federal Reserve study.
Inverted Yield Curve Shape: Short-term yields higher than long-term yields. Siren call that a recession is coming. The bond market believes the Federal Reserve is keeping monetary policy to tight and money supply growth to low. The last seven recessions have been preceded by an inverted yield curve 9 months – on average - in advance. If yield inversion is greater than 2.4 percentage points, then probability of recession is 90% in the next 18 months.
Market Analysis:Bonds: Yield curve represents bond marketStocks: Stock prices are based on expectations of future profits and economic activity, so the yield curve can serve as an
effective market-timing strategy toolDollar: Inverted Y.C. may reduce foreign investor appetite for U.S. assets if believe recession is coming => $. However,
an inverted Y.C. may attract “hot money” into U.S. investments if short-term U.S. interest rates are significantly above overseas short-term interest rates => $
Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve.
Bank run Many depositors simultaneously decide to withdraw money from a bank. Bank panic Many banks experiencing runs at the same time.
Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits.
Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves.
Excess reserves Reserves that banks hold over and above the legal requirement.
Fractional reserve banking system A banking system in which banks keep less than 100 percent of deposits as reserves.
The Federal Reserve System
How the Federal Reserve Manages the Money Supply
Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives.
To manage the money supply, the Fed uses three monetary policy tools:
Open market operations The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply. Federal Open Market Committee (FOMC) The Federal Reserve committee responsible for open market operations and managing the money supply
Discount policy Discount loans Loans the Federal Reservemakes to banks. Discount rate The interest rate the FederalReserve charges on discount loans.
Reserve requirements
CurrencyCHK Dep.sSavingsMMDACDs
Other assets
Assets HHs Liab. + NW
Loans
Net Worth
Assets FED RES Liab. + NW
Assets BANKs Liab. + NW
CHK Dep.sSavingsMMDACDs
Disc. Loans
Disc. Loans
Net Worth
Currency inCirculation
Reserves
Treasury Bonds
Loans
Reserves
Treasury Bonds
FX Reserves
Reserves = Required Reserves + Excess Reserves
Required Reserves = 10% x CHK Deposits
Reserves = Vault cash+ Deposits at Fed Res
Req. Reserves+10
Loans+90
Deposits+$100
HH SectorCash = $100
Cash -$100Dep. +100
Bank A
Req. Reserves+9
Loans+81
Deposits+$90
Credit Union B
Savings & Loan C
Req. Reserves+8.10Loans+72.90
Deposits+$81
Deposits+$72.90
Req. Reserves+7.29Loans+65.61
Federal Reserve
Currency in Circulation -$100
Required Reserves +100
Dep. +90 Loans +90
Dep. +81 Loans +81Bank D
Dep. +72.9 Loans +72.9
Sum = Dep. + 900 Loans + 900
The act of originating
a loan,is the act
of creating money
Banks are the heart/pump
of the economy
Assume:1. RR = 0.10 x Deposits2. Banks Max. 3. ER = 0
Curr + Chk Deposits
Clear checks between A,B,C,D
Sum of an Infinite Geometric SeriesLet OD = original deposit
Loans = 0.9 OD + 0.92 OD + 0.93 OD +…
Loans = 0.9 [OD + 0.9 OD + 0.92 OD +…]
Loans = 0.9 [OD + Loans]
(1- 0.9) Loans = 0.9 OD
Loans = 0.9 OD (1 - 0.9)
Loans = 9 (100)
Loans = 900 = Deposits
Loans
Excess Res.+100
T-Bills-100
Excess Res.-100
Loans+100
HH SectorAssets Liabilities
Bank A
Req. Reserves+10
Loans+90
Deposits+$100
Credit Union B
Savings & Loan C
Req. Reserves+9
Loans+81
Deposits+$90
Federal Reserve
Reserves +100
Dep. +100 Loans +100
Dep. +90 Loans +90
Dep. +81 Loans +81
The act of originating
a loan,is the act
of creating money
Open Market Purchase1. Fed buys T-Bill from bank A2. Bank Excess Reserves3. r = reserve requirement = 10%
Curr + Chk Deposits
T-Bill +100
Deposits = (1/r) x Reserves $1,000 = (1/0.10) x $100
Sum = Dep. + 1,000 Loans + 1,000
AssetExchange
PortfolioRebalance
Let x = loaned out/pass through %Let r = required reserve ratio = 1 - xSum of Infinite Geometric SeriesS = 1 + x + x2 + x3 + …S = 1 + x [1 + x + x2 + …]S = 1 + x [ S]S – x S = 1S = 1/(1 - x)S = 1/r Simple deposit multiplier(ratio of chk deposits / reserves)If r = 10%, then multiplier = 10 checking deposits = 1/r * reserves $1,000 = 10 * $100
Recall Expenditure MultiplierY = (1/1-MPC) x I
Producer Price Index(Measures changes in prices paid by businesses)
Web: www.bls.gov/ppiOne revision published with 4 month lag. Annual revision in February.
PPI measures changes in prices that manufacturers and wholesales pay for goods during various stages of production. It is the oldest inflation measure; index began in 1902. Labor department issues questionnaires to 30,000 firms on 100,000 different items. A basket of goods is formed to create an index that starts at 100 and reflects average price of goods in 1982. PPI is the first inflation number of the month.
Follow price changes along the production pipeline to determine where price pressures originate.
3 progressive stages of production give rise to 3 price indexes:PPI Crude Goods – cost of raw materials entering the market for the first time (wheat, cattle, soybeans, coal, crude petroleum, sand, timber). Price
changes can be a function of changing supply which is a function of droughts, freezes, animal disease, geopolitical factors.
Core Crude Goods – (nonfood materials less energy) is a good leading indicator of U.S. and world economic growth. This index responds quickly to shifts in economic activity. Prices are very sensitive to economic turning points. If businesses expect an increase in future demand, the demand for metals, paper boxes, timber will rise => price crude goods => price intermediate goods => price final goods. Price increases move down the production pipeline.
PPI Intermediate Goods – cost of commodities that have undergone transitional processing (flour, paper, auto parts, leather, fabric)
PPI Finished Goods – final processing stage (apparel, furniture, automobiles, meats, gasoline) Products retailers pay for. Total finished goods index is a measure of inflation in the long-run. Not a perfect leading indicator of consumer price inflation.
There is a link between PPI finished goods and CPI. The two indexes may diverge on a month-to-month basis, but tend to move in tandem and are correlated over a longer (6-9 month) term. PPI does not include service prices or imported prices, whereas CPI does.
Core PPI Finished Goods – excludes food and energy prices and gives a more accurate reading of the underlying inflation trend. The core rate index is a proxy for near-term inflation
Inflation, P/P, is public enemy number one to the financial markets. An PPI => CPIA 12-month perspective is a better way to view the PPI numbers.
