China PMI comes in below expectations. Overnight stock futures down.

The Chinese Purchasing Managers Index (PMI) came in at 52.1 as reported by Chinadaily and looking at the market reaction it was below expectation.

SP 500 overnight futures are down ~0.8%
Gold down
Copper down
Bonds up
You can see delayed CME futures quotes if you want to watch the action tonight.

Clarity on debt levels in China. They are high.

Getting precise numbers out of China is always challenging but data is slowly coming out. . .  From the Telegraph

Chinese provinces are, in some cases, equivalent in size to major European countries and run with a degree of fiscal autonomy. The southern province of Guangdong, for example, has the same population size as Germany. However, provincial budgets have been classified as state secrets until now and this is the first time that China has disclosed the level of local government debt.
Mr Liu said the ratio of debt to disposable revenues at some local governments was over 100pc and in the highest case it was 365pc. . .
Victor Shih, a professor at Northwestern University in the United States, believes the sum in 2009 was 11.4 trillion yuan, equivalent to 71pc of China's nominal GDP.
Mr Shih has warned that local governments have also succeeded in rapidly funnelling large amounts of debt off their balance sheet and into public-private investment vehicles.

ht Metalminer

No one is talking much about deflation . . . yet.

US Treasury rates have dropped recently and it appears to me they may continue declining.   How low can they go?  I have no idea but I thought it would be interesting to look at when 'deflation' was a popular search term on Google.  Click on the screen capture at the right and you'll see searches spiked around the same time long term US Treasury bond yields dropped very quickly.

I wonder if we'll get another spike in search traffic for deflation if bond yields fall again . . .

A head and shoulders on the stock market?

The market action today did some technical damage.  As you can see from the chart below (provided by Stockcharts.com) a classic 'head and shoulder's' pattern appears to be forming in the S&P 500.  If the market goes down much further the technicians may consider the pattern formed and they'll sell sell sell.

Overall it was an ugly day for risk assets with stocks, energy and base metals falling.  The dollar, gold and US Treasuries were all positive.   The quarter ends tomorrow so the exciting market action may be not be over with.

I was only joking about Greece selling islands!

I was only kidding!
When I joked (here and here) about Greece selling off some islands it was entirely in jest.

Evidently Greece is now putting numerous islands up for sale in an attempt to pay down some of their debt. From the Guardian:

Now Greece is making it easier for the rich and famous to fulfill their dreams by preparing to sell, or offering long-term leases on, some of its 6,000 sunkissed islands in a desperate attempt to repay its mountainous debts.

Only 227 Greek islands are populated and the decision to press ahead with potential sales has also been driven by the inability of the state to develop basic infrastructure, or police most of its islands. The hope is that the sale or long-term lease of some islands will attract investment that will generate jobs and taxable income.

ht: BusinessInsider

Hugh Hendry takes on . . . . Everyone

Mr. Hugh Hendry is always fun to watch and even more so in this interview:





He discusses the euro, china, George Soros and the 'axis of financial evil'. 

ht: Zerohedge

Is a steep yield curve leading us astray?

Does a steep yield curve guarantee future economic growth?  Usually but maybe not this time.

A recent article on BusinessInsider got me thinking about the yield curve and its power to predict when a recession is NOT likely. 

The article title and copy was interesting:  Unless 'This Time It's Different', There's Now Zero Chance Of A U.S. Double Dip

Substantial research suggests that the difference between interest rates for 10-year and 3-month U.S. treasuries is a reliable leading indicator for the U.S. economy, so much so that the New York Federal Reserve even creates charts using this metric, boldly titled "Probability of a U.S. Recession".
Let's hope the science holds, since according to the New York Fed's latest chart there's almost zero chance of a U.S. recession now. In April, the treasury-spread-based probability of recession collapsed to 0.04%.
We're not going to claim we're completely sold on this metric, but have to concede that historically it has worked and it's also hard to imagine why the U.S. would fall back into recession in the near-term given the rebound already in place. Things would have to start deteriorating first, and we haven't seen that yet. Should this time be different? That's not a rhetorical question. You can read the New York Fed's justification for this metric here and decide for yourself.

Here's the chart produced by the NY Fed as of June 21, 2010 which BusinessInsider refers to. As you can see it is saying there's effectively NO chance of a recession anytime soon. 

This relationship is considered so solid the yield curve is part of the leading economic indicators published by the Conference Board where the yield curve is 10% of the LEI index.

Even Krugman of the NYT has commented on how a steep curve implies positive future growth.

Now, this spread could be fairly small if people expected the economy to remain in the dumps for a long time; see Japan. What the large spread now tells us is that the US economy is in the dumps now, but that investors see a reasonably good chance of a strong recovery in the not-too-distant future. That’s good news, not bad news.

Both the Fed and Pimco have web sections devoted to discussing the yield curve and its predictive powers.

Substantial research from the Federal Reserve on the yield curve shows it is a good predictor of future economic growth.
From Federal Reserve: July/August 2006 - Current Issues:

Conceptual Considerations
The literature on the use of the yield curve to predict recessions has been predominantly empirical, documenting correlations rather than building theories to explain such correlations. This focus on the empirical may have created the unfortunate impression that no good explanation for the relationship exists—in other words, that the relationship is a fluke. In fact, there is no shortage of reasonable explanations, many of which date back to the early literature on this topic and have now been extended in various directions. For the most part, these explanations are mutually compatible and, viewed in their totality, suggest that the relationships between the yield curve and recessions are likely to be very robust indeed. We give two examples that emphasize monetary policy and investor expectations, respectively. . . .

Here's the important part . . .

A rise in short-term interest rates induced by monetary policy could be expected to lead to a future slowdown in real economic activity and demand for credit, putting downward pressure on future real interest rates.

So an inverted yield curve chokes lending which then slows economic growth.  Conversly a steep yield curve induces lending which stimulates economic growth.  Lets look at some data provided by the Federal Reserve from 1974 onward comparing yield curves and recessions.  As you can see there is a strong relationship between the two. In all cases an inverted curve preceeded or coincided with recessions as shown by the gray recession bars. Furthermore no recessions occurred without a yield curve inversion (or nearly so) happening beforehand.  Also note how steep the yield curve is now as compared to recent history.  Rarely has the curve exceed 4%

It's no wonder the steep yield curve is considered such a reliable indicator.

Let's take it one step further and look at the relationship between a steep yield curve and economic activity through the mechanism of lending growth. This graphic adds bank loans and leases at commercial banks.  Looking at the graphs you can see in each case an inverted yield curve resulted in a recession and a slowdown in lending.  Once the yield curve returned to 'normal' with higher long term rates bank lending resumed growing and the country exited a recession  . . . except this time. Bank lending continues to decline which is exceptional.  (Before you get excited about what appears to be a sudden spike in the rate of lending you should know that is due to off balance sheet lending vehicles being brought back onto bank balance sheets.  Annaly's blog has the details.) 

Annaly's recent blog post on debt and GDP growth reinforces the previous picture.  Real credit market growth is strongly linked to real GDP growth. 

My contention is the steep yield curve is no longer an accurate predictor of future economic growth due to the lack of credit growth.

Has there been another time when a steep yield curve has led us astray?  Yes.  Robert Shiller provides some excellent long term historical data going back to the 19th century.  Let us examine some data from 1928 through World War II. While the data fields are not precisely similar they are close enough to provide analogs to modern data sets on this topic. 

Here the difference between 1year and 10 year rates is shown as compared to real earnings on the Standard and Poors equity index. 

While this does not show lending activity it does show what one would hope results from increased lending namely earnings growth.

Some interesting relationships can be observed:

The yield curve was very inverted in 1929 and returned to a 'normal' curve in 1930. Earnings did rebound from their lows but did not exceed their 1929 peak until after World War II.

More importantly a serious fall in earnings in 1937 coincided with a non-inverted yield curve.

The rarely mentioned mechanism (credit growth) between a steep yield curve and economic growth is not working.  It is my contention until credit growth at least stops falling the steep yield curve rule of thumb should be ignored and one should be concerned with very tepid (if at all) real GDP growth.

If my thesis is correct and this rule is broken it could come to quite a shock to those who consider it dogma. Considering the yield curve is part of the Leading Economic Indicators from the Conference Board it may well be used by many in portfolio allocation decisions.   If you hear in the future how the steep yield curve is showing how we can't go into a recession remember the yield curve alone does not create economic growth but creates the opportunity for increased credit growth which then causes economic growth.

This Time It's Different.

Sources:

Federal Reserve FRED data
Federal Reserve section on steep yield curve

Robert Shiller

edit 01/28/11: As has been pointed out to me in other conversations Japan has had a few recessions over the last 15-20 years while their yield curve has not been inverted.