Allison's Ode to the Second Moment


Welcome to the 53rd issue of Allison’s Ode to the Second Moment, a newsletter that will tell you exactly when the next recession will start and what will cause it—because that is definitely possible.

Let’s Talk about the Yield Curve

I am starting to think the inverted yield curve is the new Phillips curve. There is a strong, undeniable correlation between an inverted curve and an imminent recession, but I’ve never heard a convincing reason why that’s true. It is just a correlation without a theory to explain it. Sound familiar?

It is just like the original Phillips curve, which demonstrated a strong negative correlation between inflation and unemployment, but no one knew why, and that’s probably why stagflation left policy makers in the lurch.

I don’t like to make predictions, but correlations without a theory usually and eventually fall apart, especially when they are based on half a dozen observations.

Now that the yield curve is flattening, people—including powerful policy makers—are worried. There is even talk of the Fed explicitly targeting a yield curve shape, which seems weird to me. Am I the only one who has bad feelings about Operation Twist?

Stephen Williamson doesn’t think people should be worried because the yield curve inversion that matters is on the short end of the curve. The behavior of the long end—where the action is happening now (or not happening because it is not moving up enough)—has less predictive power. He also argues recessions tend to follow a big increase in the short rate, normally brought on by Central Bank policy. Why is not clear. Are central bankers raising interest rates because the economy is accelerating as it reaches the end of the cycle or did increasing rates cause the recession?

In any case, short rates have another 200 basis points to go before they are in recession-causing territory. There are certainly reasons to worry this cycle is reaching its peak, but the yield curve shape is not one of them.

The Upside of Low Rates

Most market commentary assumes rising rates are all bad because they increase the cost of debt. But most of the time, a regime change creates winners and losers.

On the plus side, rising interest rates have improved pension funding ratios. Higher rates also are better for insurance companies. They can charge lower premiums and that means lower annuity prices. Retirees will get more income, if they annuitize or even self-annuitize, and that means they can spend more.

Democratic Socialism and MMT

I am a confused by the zeal to reclaim the word socialism and use it to describe good, happy things. I was even more confused by this story about Congressional candidate Alexandria Ocasio-Cortez that made two contradictory assertions:

  1. Economists who worry about debt are “quacks.”

  2. Ocasio-Cortez understands economics because she has a degree in it from BU.

Both of these things cannot be true. By her definition, the BU economics department is full of quacks, so what does that say about her economics degree?

Economics students learn that most choices involve trade-offs. For example, you can’t tax without losing some efficiency; you can’t cut spending without hurting people who depend on benefits; and you can’t logically claim credibility because you have a well-respected, mainstream economics degree and use it to advocate a fringe view. Jeffrey Brown cautions against abandoning economic logic to further a politically convenient position. Both sides are guilty here.

I do admire Ocasio-Cortez's objectives and her vision for a fairer, booming economy. There is a lot of low-hanging fruit that can reduce inequality and enhance growth. Here’s what I’d suggest:

  1. A progressive consumption tax

  2. Pay for the entitlements we already promised

  3. Expand the Earned Income Tax Credit

  4. Reform state and municipal pensions to free up more revenue to finance infrastructure spending (which mostly happens on the state level)

  5. Reform occupational licensing laws

  6. Reform non-compete agreements (already happening)

That’s a start and a lot easier than a guaranteed job program. I guess I am into incrementalism. Or, I am generally not a fan of creating a first-order cost to solve a second-order problem. It is high risk with little reward.

Systemic Risk Is Everywhere

Bloomberg is worried that corporate balance sheets are over-levered and we are all on the hook. They looked at 69 companies that are sitting on $1.2 trillion of debt—most of it rated junk and due within a few years.

How did it get this way? Bloomberg argues the Fed’s low rate policy set off a search for yield, where investors (even mutual fund investors) would lend to pretty much anyone. I buy the search for yield. When the risk-free rate falls, many investors (pension funds, for example) can’t afford low-risk investments if they hope to pay their liabilities. I am not sure I totally blame the Fed. Rates are low for several reasons.

Meanwhile, the New York Fed is worried about systemic risk in the market for treasuries. If a high-speed trader goes down, there is a risk the whole system could collapse.

Wow, danger everywhere! Here is a meaningful indicator: once everyone has their own reason why a recession is coming soon: the yield curve, high-frequency trading, corporate debt, geo-politics, take your pick, something is brewing.

In Other News

Finally, some very sad news: the original pension geek, Jeremy Gold, has died. An iconoclast actuary; he argued pension funds should account for risk. It sounds so obvious; but it was revolutionary at the time, now his ideas are in the mainstream, and the world is better for it. Mary Walsh wrote a beautiful obituary.

Until next time.