The Treasury Yield Curve and Stagflationary Thoughts

Using monthly data going back to July of 2001, I have come up with the following closest match to the shape of the current yield curve (as of April, 2009). I used a least squares approach with all time periods being equally weighted.



As you can see, the shape of the yield curve in November of 2002 is extremely similar to the shape of the yield curve in April of 2009. The only real difference is the overall change in interest rates. They fell.

Using hindsight, November of 2002 was a really good time to be buying stocks, assuming you sold them before they came crashing back down to even lower levels in 2008 that is.

Interest rates have been falling for decades. Some of it can clearly be seen in the chart above. If the trend continues, interest rates will need to go negative to keep the party going during the next downturn. How's that going to work? Just imagine how great it would be if it truly did work though. Our government would earn interest on all the debt it has. Can't you just picture negative 1% interest rates? Prosperity baby! For each trillion we owe China, China could pay us $10 billion annually. Problem solved! Sarcasm!

Mankiw's Negative Interest Rate Solution?

One outcome is implementing Mankiw's theories and hoping nobody screams currency crisis in a crowded movie theater. Yeah, I really like that one. Maybe he can get Japan to try it first, lol. Sarcasm! Another outcome could be using inflation as a way to simulate negative interest rates. We saw how well that worked last time. How high did oil go before things seriously fell apart?

The question of the century therefore continues. Do I brace for deflation or inflation? I've been a bear since 2004 and I'm still not sure.

If the price of housing is any indicator, then we bought way too much stuff on credit. It seems unlikely that buying MORE stuff (hoarding) and/or piling on more debt is the greatest of plans. That's the deflationist in me talking.

However, Ben Bernanke said, "But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services."

I believe it is a threat. I believe it is credible. I believe it truly creeps me out too. Perhaps I never really thought of a monetary printing press that can create dollars at essentially no cost as being some sort of technological breakthrough. That's the inflationist in me talking.

What do I do when I feel threatened? No matter how much money appears, all I seem to do is hoard future needs. Is going to the mall a future need? Not really. Is eating at restaurants a future need? Not really. Doesn't our economy need people going to the mall and eating at restaurants? That's the long-term stagflationist in me talking.

Perhaps our economy shouldn't need people going to the mall and eating at restaurants as much as it does though. Wouldn't it be nice if our "advanced economy" didn't import much of what it needs from other countries? Oil? Made in China? That's just me being bearish again. Sorry!