Steve Blitz Morning Notes

There has been a lot of talk lately about the steepening of the yield curve, as if this is a bad thing. Even the Fed seems bent on keeping longer term yields from getting too high and aborting mortgage activity -- refinancing and otherwise. Truth is a steep yield is a necessary although not an entirely sufficient requirement for economic recovery. The curve is not a talisman, it works as a forecast of economic activity because it indicates whether banks are making money or not. When they are they lend and when they aren't they don't.

The chart above illustrates the historic interplay of Fed policy, the curve and unemployment. Before every recession the Fed tightens, the curve flattens until it goes negative and then the recession begins and unemployment rises.

Since 1982 it takes less and less of a rise in the funds rate to create a negative yield curve and not as negative a curve to tip the economy into recession. While the curve doesn't need to get as negative to send the economy into a tailspin it is taking steeper positive yield curves with a lower funds rates to get the economy restarted. Employment, as always, follows with a lag.

A good part of these dynamics of the past 30 years relates to lower inflation rates but a good part also owes to the increased and increasing indebtedness of the economy, corporate and household. It does not take much of an increase in high real interest rates to make leverage a burden and create the subsequent drop in activity. Conversely, with so much debt on the books and inflation low it takes a much longer period of low rates and a steep yield curve to get credit creation growing at the rate where an economic recovery can take hold.

The yield curve is finally steep enough to begin to turn the economy and put a cap on the unemployment rate -- if the Fed lets well enough alone. At this stage of a downturn, a market pricing in concerns about inflation and crowding out is a good thing -- it means investors are thinking recovery not depression. There is a whole cadre of healthy financial institutions ready to step in and fill the void left by the financial leaders of the past cycle. Still, every cycle since 1982 has taken that much longer for recovery to take hold and get unemployment back to pre-recession lows. This cycle will prove the same and more so. At least the bottom seems to be behind us.