Curve (Not) Crazy

On August 30, 2006, the Bureau of Economic Analysis (BEA) reported preliminary estimates for US Gross Domestic Product (GDP) in the second quarter. It was figured back then that domestic output increased 2.9% over the first quarter, seasonally adjusted, somewhat of a decrease from the robust start to 2006. Final estimates for Q1 thought the economy had advanced 5.6% during those three months.

These were comforting numbers for financial markets increasingly shaken by financial factors. Anecdotes about housing imbalances were plentiful, of course, but more so there was a growing and obvious objection to Alan Greenspan’s sunny view of everything.

The FOMC had begun to “raise rates”, that is, the Federal Reserve started a series of seventeen 25 bps adjustments to its one target for the federal funds money market rate, all the way back in June 2004. The long end of the UST curve wasn’t buying the rationale behind the policy shift.

Thus, over those many months, the Treasury bond curve flattened out and then in December of 2005 it inverted. The “maestro” called it a “conundrum” when it was anything but. The market, the most important market in the world, flat out disagreed with the Chairman. He just didn’t care. Central bankers don’t actually believe in markets, they believe in their statistical models.

When the BEA issued forth its statistics on the economy, policymakers thought their math had been checked and they were right about everything. A bunch of wet blanket Cassandras among UST investors weren’t going to spoil the successful engineering of recovery from the perilous dot-com bust. Buoyed by this imagining, officials entered 2007 supremely confident.

Very quickly everything would change, however, wherein the FOMC hurriedly and more desperately found that it had been wrong and was then behind events taking shape much faster than they could respond (let alone understand anything so as to respond effectively). The UST market was right all along.

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