Tuesday, May 31, 2016

How informative is the slope of the Yield Curve?

The yield curve is becoming flatter. The difference between the 10-year and 2-year government bond is now approaching 1%. The yield curve tends to get flatter when the economy reaches the end of an expansion phase and it is many times seen as a predictor of future recessions.

But interest rates are not what they used to be. If short-term interest rates are stuck at zero, all the movements in the yield have to come from long-term interest rates. This is the opposite than what we have seen in previous cycles where all the action has come from short term rates.

The 2-year rate is not quite zero and has been moving recently, so an interesting question is whether the yield curve is once again driven by movements in short-term rates. Not quite. Let's calculate the correlation between changes in the slope  of the yield curve (measured as 10 year minus 2 year rates) and the changes in the 2 year rate. The correlation [calculated over a 3 year window] is plotted below.


If the 10 year rate did not move and all the action was coming from the 2 year rate this correlation would be -1. Prior to 2011 this correlation was always negative and in some cases as high as -0.6 signaling the importance of changes in short-term rates as drivers of changes in the slope of the yield curve.

But as of the summer of 2011 this correlation has turned positive indicating the importance of movements in the long-term rates and the way they are correlated with the 2-year rate. As an illustration: an event that causes both short-term and long-term rates to move down but where the 10 year rate falls by more would lead to a positive correlation between changes in short-term rates and changes in the slope of the yield curve.

So we are living in a new world where change in the slope of the yield curve are driven by a combination of changes in both short-term and long-term rates that are not easily mapped into previous cycles. Where the yield curve goes from here is an open question. A strong recovery and an increase in inflation expectations could result in an increase in its slope and possibly the return towards more normal times. A negative event could potentially lead to a further flattening of the yield curve and one more step towards Japanification of the US economy.

Antonio Fatás

Wednesday, May 4, 2016

World growth: mediocre or pathetic?

The recent disappointing performance of the world economy has been labelled as the "new mediocre" by Christine Lagarde, the "new reality" by Olivier Blanchard and the "new normal" by many others.

How mediocre is global growth? The answer to this question heavily depends on the way we measure world GDP. Aggregating national GDPs can be done in two ways: using market exchange rates or using PPP (purchasing power parity). Because PPP puts larger weights on emerging markets and because these countries have shown faster growth rates in recent decades, the two measures have been diverging over time and now they offer a very different picture of the state of the world economy.

Below I plot world real GDP growth rates (smoothed by taking a 7-year centered average) measured at market exchange rates and PPP (both data are produced by the IMF).

During the early 80s both measures were identical because emerging markets did not grow faster than advanced economies (plus their relative size was smaller). Since the 90s the gap opens and reaches a maximum of about 1.5% a year during the mid 2000s, the time when emerging markets were growing at their fastest rate.

What do we make of the last decade? Using the PPP yardstick it simply looks like a return to the rates of early decades. The exceptional years where the 2003-2008 period where the world grew above 4%. Rates of 3-3.5% look normal.

But using market exchange rates recent data paints a picture of mediocrity (or worse). Rates in the range 2-2.5% are very low by historical standards. The last years feel like the worst years we have since in terms of growth.

Which of the two numbers is the right one? The use of PPP is justified when measuring improvements in living standards. The larger weight given to emerging markets makes sense given that the volume of goods and services they produce is larger than what a market exchange rate conversion suggests.

But from many other perspectives market exchange rates make more sense: financial flows are aggregated using market exchange rates so from the perspective of financial markets the market exchange rate GDP measure might be more precise. Also from the perspective of a multinational company looking at the world economy as a source of demand market exchange rates are likely to provide a better picture of the state of the world.

It is therefore not surprising that when we look at the state of the world economy what looks like returning to earlier growth rates for some might look like mediocre (or even pathetic) growth for others. Make sure you read the footnote before you check the next chart on the state of the world economy.

Antonio Fatás

[And talking about footnotes here are two: First, the data above includes forecasts for the years 2016-2018 to calculate the last years in the chart. Second, an interesting question is what happens to world growth rates as PPP rates change -- one day prices in emerging markets might be as high as those in advanced economies. This is not captured in the chart above. The IMF and others use the latest PPP estimates (2011) as a base for international prices when calculating PPP adjusted data for all years in the sample.]