March 3rd, 2015- You don't have to be Columbo to figure this one out, but a little sleuthing nevertheless can go a long way. The mystery surrounding the equity markets' decoupling from a clear majority of economic phenomenon (manufacturing data, dollar strength, market-based inflation expectations just to name a few) can be solved by looking at what it is actually coupling too. In this case, it is the odd and unexpected marriage of the S&P 500 to that of the Treasury yield curve difference.
Once polar opposites, the cozy relationship enjoyed by that of the U.S. Treasury yield curve difference (the spread of the 3mo/10yr minus that 2yr/30yr) and the S&P 500 is now celebrating its 2 year anniversary. A forced arraignment, it would seem, at the unwilling hand of the Federal Reserve. In was in March of 2013, of course, that the Fed began signaling a return to "moderate" economic growth which implied that its current habit of large-scale asset purchasing was starting a transition to an end.
This is important because the Fed had been tightening regulations concurrently with purchasing high quality debt securities. Therefore, the logical consequence to reducing monetary policy accommodation would be to loosen regulatory policy. After all, accommodation had benefited the broader economy at the expense of the financial sector. However, regulatory pullback, to this day, remains scant to be seen.
To understand the implications of all this, we need to get a better understanding on what the yield curve difference is all about.
The yield curve difference is a function of the spread between the 3mo/10yr U.S. Treasury yield curve minus that of the 2yr/30yr Treasury yield curve. The latter measures the relative real-time health of the broader economy whilst the former that of the financial sector. Given the U.S.' transition into a service-centric economy around the year 2000, the financial sector is now, by far and away, the most significant sector of said economy. Since the 3mo/10yr curve is shorter in duration and thereby instantaneously affected by the Federal Reserve, it does a tremendous job in relaying information concerning the financial sector. By way of comparison, the 2yr/30yr curve is much longer in duration and its relevance in underscoring actual trends in the broader economy are, at this point, well established (close to the point of being above reproach.)
By taking the spread of the financial sector curve and subtracting it from that of the economic curve you can infer, therefore, the relative health of the financial sector to that of the broader economy. Since March of 2013, the difference has marched higher with unabated consistency. This has been overridingly due to the 2yr/30yr curve flattening back towards the economic optimization zone of 175 basis points. (This would be the zone that reflects an economy that is growing within an acceptable degree of its potential.) The 3mo/10yr curve, though, has not enjoyed the same fruits of the Fed's LSAP seedlings.
The financial curve relative reluctance to join its Treasury curve counterpart's euphoria is a direct result of the Fed's unwillingness to scale back the heavy regulations set in place since 2009. While an increased regulatory environment served to counterweight the asset purchasing, it now serves as an impediment to the financial sector's ability to maintain the economy's momentum. After all, in an economy dominated by surplus productivity, it is the financial sector's job to provide the economy with as much smart leverage as possible or face an unbridgeable output gap.
So it is the relative increasing significance of "left behind regulation" that is forcing the yield curve difference higher. This is also the reason why growth-based markets (like that of the S&P 500) are moving along briskly despite decoupling from more traditional bell-weathers. Growth securities see interest rates as too low and therefore assume money is cheap. Business school 101, therefore, tells them under such assumptions to spend money. However, given the lack of real demand as a function of a desolate leverage landscape, the spending flows mainly to such things like paying dividends and buying back stock.
But the financial sector knows that is not the case. In fact, the financial curve is telling us the interest rates are too high and leverage too low. Failing a repeal of regulations or reopening of LSAPs (or a combination of both), subsequently, means liquidity issues are bound to surface again in what has become its traditional severe and sporadic fashion. This would push both curves back into inverted territory and force the Fed's hand to increase liquidity.
So if the Fed wants to be bold in its proclamation that it can raise interest rates, it would be best served to first lower financial regulations. The fact that they wouldn't would be a real head-scratcher, even for a detective like Lt. Columbo.
New Era Monetary Policy
What's a Fed to do in this day and age of surplus productivity? Well, that is exactly the question we aim to answer on this page by highlighting and stipulating upon the effects of monetary policy on the financial sector as well as the broader economic landscape.