VIX, VXO and VXN vs SOX on Weekly Charts Back to 1994
3 Year Daily Charts vs the BPNDX and BPCOMPQ:
Interestingly enough the all time record low for the semi equipment btb was established in April 2001. The actual low for the SOX in this cycle as you can see was in October 2002. By then the VXO had spiked over 50 for a third time in less than 13 months. And the BPNDX had hit 5 lows of less than 20 during that time period while establishing a positive divergence. Each of the major three BPNDX lows was higher even as the SOX set lower lows.
The btb alone probably has little predictive value concerning what direction the SOX will trade. It is most important to watch volume using the SMH and components for clues because which direction the SOX is going to trade is determined by institutional traders.
Volatility Indices versus the BKX on Weekly Charts back to 1994:
VIX, VXO, VXN vs COMPQ on Weekly Charts back to 1994:
On the face of it, inverted yield curves are a big paradox. Why would anyone lend at higher interest rates for the short term and at lower interest rates for the long term? The current theory would tell you that long term investors settle for a lower interest rate now, if they believe that the interest rates would go down even further in the future. Analysts would tell you with a glee that, by doing so, the long-term investors have the final laugh when the recession knocks on the doors of the economy within a few months of the inverted yield curve occurrence. The long term investors are supposed to lock in decent rates before the bottom falls out.
Does this explanation make sense? By this explanation, there are supposed to be some investors who are aware that the economy is likely to go into recession even before the inverted yield curve occurs! They then decide to have the last laugh and then lock in at lower interest rates so that the yield curve gets inverted. By this logic, our investors are supposed to have some other economic indicator with them which is much much more accurate than the inverted yield curve! And what that economic indicator is – the current thinking is silent on it.
The mistake that the current thinking makes is that it lumps the entire financial market into one. Actually the financial market of our economy is divided into two relatively disjoint systems. Let us take an example.
Suppose Stella earns 5000 dollars a month. She spends 2000 dollars on her immediate needs – whether it is house rent, daily necessities or food. She spends another 1000 dollars on irregular or once in a while needs – books, music, entertainment, occasional purchase of durables etc. As a prudent person, she dutifully sets aside 1000 dollars so that she can make some long-term investment, either in shares or in long-term bonds on in fixed deposits. The remaining thousand dollars, she would not know what to do with it. It just lies in her bank account, getting accumulated month after month. Most of us do not have a ready plan each and every month on what to do with what we earn. Most of the time, there is a portion of our income lying idly in our bank accounts. This idle many is not completely useless, it acts as a safety net should we suddenly require some extra money. After accumulating thousand dollars per month for the next one year, Stella might suddenly decide to use up all the accumulated cash of 12000 dollars in buying a car. Or she might even convert it into savings at a later date by investing the accumulated cash in some fixed deposits.
If you see here, the income in the above example is divided into three parts. Out of the earnings of 5000 dollars, Stella immediately spends 3000 dollars on consumption needs, she saves 1000 dollars and with regard to the last 1000 dollars, she is undecided on what to do with it. So 3000 dollars is her planned consumption, she consumes this portion of the income as soon as she earns it. 1000 dollars is her planned savings, she invests these. And the remaining 1000 dollars is her unplanned income – this income of Stella is unplanned. She does not know what to do with it, she would not want to tie this down in any long term investments as it serves as her safety stock of cash which she needs at her beck and call.
In the above example, the unplanned income of Stella is nearly 20% of her total income. If every Stella of the economy has an unplanned income of 20%, what would happen? 20% of the economy’s cash would lie idle in bank vaults! Money circulation gets disrupted and the economy would get strangled. A healthy economy should not have such huge sums of idle cash. Fortunately, financial markets step in to do the damage control for us.
Not all of us are equally wealthy. There are those who are wealthy and have lots of unplanned income and there are those of us who spend in excess of our incomes because we are not so wealthy. Even among those who are wealthy, there are some who spend in excess of their incomes. So those who spend in excess of incomes borrow the idle unplanned incomes of those who spend less than their incomes. And the short-term financial markets act as the mediators between these two groups.
Stella has an idle cash of 10000 dollars which has accumulated over the last few months and she might not use it for the next one year, say. During the time that she decides on what to do with her money, the bank that has her account lends out this money as short-term loan to some Jack for buying a car under the agreement that he would repay the loan in 3 months. The bank charges some fee in the form of short-term interest and earns some income out of it; the fee normally covers the risk factor as well. Once Jack repays the loan, Stella’s money is once again lent out to someone else for another three months. This way the consumption needs of four individuals can be met with the idle cash of Stella! Note that the bank with the account of Stella cannot lend her money on a long-term basis because Stella might withdraw her money at any moment; she has not made any commitment to save this money for a certain period of time.
This is not just about households, this applies even to the corporates. Some large firm has billions of dollars of profits lying in bank vaults. It is busy in drawing some investment plans and it might finalize on a big project in a year or two. During this time, this idle cash can be lent out as short-term cash to some other firms which are in need of working capital for operating their business. This money can even be lent out to households as consumer finance.
So there are two financial markets in our economy. One, the long-term investment market where the savers meet the investors. Long-term interest rates operate upon this market. Two, the short-term finance markets, where those with idle cash lend out their money to those who spend in excess of their incomes, usually for short durations. Short-term interest rates operate upon this market.
Let us call the total idle cash of all those in the economy who spend less than their incomes as Unplanned Income. This would include three components – the unplanned income of the households, the unplanned income of the corporates, and finally the cash reserves of the banks and financial institutions. Banks and Financial institutions can always borrow money from the central banks of the respective economies and then lend out that money to firms and households as short-term cash. So the idle cash reserves of the households and corporates can always be augmented to some extent by the credit expansion of the central bank money supply. Similarly let us call the total quantum of money in the economy spent by all those who spend in excess of their incomes by borrowing as Borrowed Consumption.
So are there any identifiable trends in the patterns of unplanned income and borrowed consumption? When is each of these variables likely to be high and when are they likely to be low? With respect to the Unplanned Income, there are three identifiable patterns.
When the economic activity is on the lower side, we spend relatively less and are likely to have huge reserves of idle cash with us. This usually happens during recessionary periods. Then as the economic activity gathers momentum and as the economy sets itself into the boom phase, we start spending more, our idle cash reserves start shrinking. As the boom marches ahead, economic activity gathers more and more speed year on year. And as the economic activity gathers speed, we start spending more and more of our incomes as soon as we earn them, the unplanned income of the economy starts shrinking in size. At the peak of a boom we are likely to have the least amount of idle cash or unplanned income.
Also it is not difficult to observe that when firms make huge profits, they are likely to hold huge reserves of unplanned income and as their profits dwindle in size, they are likely to be cash strapped and are likely to hold lesser and lesser amounts of unplanned income. And here is a common sense imagination of patterns in profits. At the start of a boom, the firms are likely to wake up to some unexpected and huge profits. This sudden spurt in profits galvanizes the firms and the economy gathers speed and we are on course to a long boom. Then as the boom progresses, the profits start dwindling in size year on year such that after a few years, profits dry up triggering a recession. I have dealt with this more detail in the article the Market Failures and Business Cycles published earlier on this site. So in the initial years of a boom, the firms make huge profits and are therefore likely to hold huge levels of unplanned income and in the later years of a boom, they make smaller profits and are therefore likely to hold lower levels unplanned income.
Another pattern is related to money. Our economies are rarely ever static. They keep growing year on year. As our economies grow, they need more money as well. Our central banks keep a tab on the money supply requirements of our economies and they try to match the money supply growth with the product supply growth of our economies. However our central banks did not always have this flexibility of matching money supply growth to our economic growth. Prior to Great Depression of the 30s, most economies were on Gold standard. When new gold reserves were found, the money supply of the economies prior to 30s increased which galvanized the economic activity. Then after a few years of strong economic activity, the new found money supply was used up leading to cash crunch in the latter years of the boom ultimately ending up in recession. When the economy is cash strapped, it is unlikely to hold huge reserves of unplanned or idle cash.
In all the above three patterns, we note one thing – during the initial years of the boom, the economy is likely to hold huge levels of unplanned income; then as the boom years progress, the unplanned income of the economy gradually dwindles and is the lowest in size at the onset of a recession. Or simply put, as the economic activity gathers momentum with the progress of the boom, the economy becomes more and more planned – the planned component of our income increases in size while the unplanned component keeps diminishing. Even though fed or central bank keeps pumping funds that increase the levels of unplanned income, as the boom progresses, the unplanned resources are used up faster than the rate at which fed pumps in the money.
What about borrowed consumption? When is it high and when is it low?
As described above, during the initial years of the boom, the unplanned income or the short-term cash availability in the economy is high. Banks are saddled with large amounts of idle cash and this depresses short-term interest rates. Very low interest rates make borrowing attractive and propel borrowed consumption in a big way. High spenders have a field day in borrowing and spending and therefore borrowed consumption is likely to be high during the initial years of the boom.
What about the latter years of the boom? As we have seen above, unplanned income levels of the economy are likely to be on the lower side during the latter stages of the boom as the economy becomes more and more planned. What does this signify? If your unplanned income is high it means that your are earning more than necessary for your immediate needs; you have a lot of extra cash in hand to meet any unforeseen needs that might arise making any possible borrowing unnecessary. If your unplanned income is low it means that you are earning just about sufficient to meet your needs and any unforeseen or unplanned needs that arise make borrowing necessary. The same thing with the economy – low unplanned income during the latter stages of the boom actually increases the need to borrow money and increases the demand for borrowed consumption. In the initial stages of the boom, the availability of huge unplanned income resources depresses the short-term interest rates and make borrowed consumption very attractive – borrowed consumption is likely to be very high on account of low interest rates. During the latter stages of the boom, borrowed consumption is propelled not by low short-term interest rates, rather, it is propelled by low unplanned income resources themselves. Low unplanned income means that market participants are earning what is just about sufficient to satisfy their needs and any unplanned needs that arise require them to borrow. As the boom progresses, there would be huge demand for short-term cash as all the capitalists try to expand their production levels to capture market shares. Also the investments that were started during the initial stages of the boom start maturing during the latter stages of the booms. Operating cash is required to start production on the new plants and this increases the need for short term cash in a big way. The same is the thing with households. Running on low unplanned income resources requires them to borrow for unforeseen and unplanned needs. Overall unplanned or borrowed consumption is likely to remain steady or might even increase through the course of the boom – initially propelled by low short-term interest rates and later propelled by the sheer necessity to borrow.
Can you see an imbalance here? During the initial years of a boom, short-term interest rates are low because of the presence of huge unplanned income resources. As the boom progresses, unplanned income or the short-term cash resources of the economy keep dwindling in size while demand for borrowed consumption keeps increasing. This continuous imbalance between supply and demand for short term cash is what causes short-term interest rates to keep rising and rising throughout the boom times. High short-term interest rates increase the cost of working capital and lead to cost-led inflation as well. Therefore even inflation keeps rising throughout the boom time along with short-term interest rates.
What about yield curves?. Having understood the reason behind the rise in short-term interest rates through the course of the boom, it is not difficult to understand the yield curves. During the initial stages of the boom there are huge unplanned income resources because of which there would be huge availability of short-term cash. Some of the cash is parked in short-term bonds and therefore there would a big demand for short-term bonds; short-term bonds prices go up because of the higher demand and their yields come down. On the other hand, long term bond investors are actually investing out of their planned savings and they demand higher yields as a compensation for the risk involved on account of the longer maturity. So we have a steep curve. Then as the boom progresses the unplanned income keeps diminishing in size and lesser and lesser amount of this money reaches the bond market. The number of buyers of short-term bonds keeps decreasing in size. However the demand for borrowed consumption is stable or even increasing slightly keeping the number of sellers on the higher side. This continuous imbalance between the supply and demand with the number of buyers continuously decreasing vis-à-vis sellers keeps pushing the short-term bond prices lower and lower on account of lower and lower demand and their yields higher and higher. There are no such systematic imbalances between supply and demand of long term bonds as investments in long-term bonds are meant for Savings and Investment market rather than for Consumption market. So while long-term yields remain steady, short-term yields keep rising and rising through the boom years converting the yield curve from steep to normal to flat and finally to inverted shape after a few years.
An inverted yield curve is an indication that there are hardly any buyers left – neither the corporates nor the households have any liquidity left to attract them towards buying short-term bonds. On the other hand the demand for borrowed consumption is steady. This large imbalance between the sellers and buyers steeply depresses the price of short-term bonds and their yield rises vertically upwards. The few interested buyers can pick and choose from the large number of sellers, demand the lowest price and get the greatest yield – leading to inverted yield curves. After a few months of trying to sell the short-term bonds despite inverted yields, the corporates realize that it is very costly affair because of the steep interest rate involved. They pull back their issuance of short-term bonds, supply decreases, which pulls the short-term bond prices up and their yields down - the yield curve reverts back from inverted shape to flat shape. However the reversal of the inverse shape does not take away the problem of liquidity which is most likely to have occurred because of low profit margins and a recession would very likely follow the inverted yield curve within a few months or a year. There are some chances of inverted yield curves not getting converted into recessions if the profitability situation improves through some prudent actions of the market participants. Otherwise they are inevitably followed by recessions.
The slope of the yield curve is a direct barometer to the extent of supplier profitability or liquidity in the economic system. The more the upward slope the higher the profitability or liquidity. The more the downward slope the lower the profitability or liquidity or the higher the cash crunch in the economic system. Currently the most accepted explanation for the slope of the yield curve is that of investor expectations. However I believe that whether the yield curve is upward sloping or downward sloping, it is more to do supply/demand forces rather than expectations. While investor expectations might play a role in creating spikes and aberrations, the general trend in the yield curve pattern has more to do with the Supply-Demand imbalance caused by the interaction between unplanned income and borrowed consumption. The slope might have nothing to do with intelligent investors who lock in and settle for decent rates expecting the bottom to fall out on account of the coming recession. I believe that there are no such extraordinarily intelligent investors who can foresee the coming downturns.
It would be interesting to observe as to how the cash crunch related to inverted yield curves finally leads to recessions. Our economy is a circular flow one where money flows from firms to households in the form of wages and then money flows from households back to firms in the forms of purchases made by the households. The money of the economy repeatedly flows to and fro between the capitalists and the households in this circular manner.
Suppose in a sample economy, there is only one capitalist Jack and only one employee Cathy. Suppose Jack employs Cathy and gives her a salary of 1000 dollars per month. When the salary is given, a money quantum of 1000 dollars gets transferred from Jack to Cathy. When revenue is realized, Jack expects to get this money 1000 dollars back in the form of sale receipts. If Cathy loans out 100 dollars to Jack as loan, she can only spend 900 dollars and therefore Jack can only realize 900 dollars through sale receipts, he would not be able to realize 1000 dollars of income. For Jack to realize his income through sale receipts, he should never take a loan from Cathy! The same is the case with the economy. Firms should never take working capital loans from households unless it is equally balanced by households taking short-term loans from firms. If they do, they are eating into their own revenues - the money that should reach them through sales revenues reaches them in the form of loan! Because of this, they would not be able to realize their expected incomes resulting in losses and a subsequent recession.
When inverted yield curves occur, when short-term yields rise higher than long-term ones, short-term bonds appear attractive to some households. Some of the household funds meant for Savings or long term bonds get diverted towards short-term bonds. Also as long term interest rates are lower than short-term interest rates, firms issue long term bonds but use cash proceeds for working capital purposes. Both ways, household fund meant for Savings is used up for working capital. And there is a lot of difference between a household fund getting invested in long-term bonds and household funds getting invested in short-term bonds. Money when saved and invested goes into the hands of the investment sector workers who then spend it on consumption goods. Saved and invested funds ultimately come back to the consumption sector capitalists as sale receipts. On the other hand, household fund invested in short-term bonds goes into the hands of the consumption sector capitalists as loans, not as sale receipts! This means that, when inverted yield curves occur, firms borrow into their own revenues on account of which they would not be able to realize their expected revenues as in the case of Jack in the above example leading to a recession!
Normally firms themselves have unplanned incomes which lie in bank vaults. This money is lent to out to households as short-term cash by the banks and financial institutions. This way households borrow from firms and any borrowing done by firms from households in terms of selling short-term bonds is offset by households borrowing from firms through consumer finance options or other means. However at about the time of inverted yield curves, the interest rates are very high; this coupled with the fact that there is huge demand for working capital in the latter years of the boom would mean that households might not borrow sufficiently to make up for the firms’ borrowal from households. This therefore finally disrupts the circular flow of money in the economy leading to firms borrowing into their own revenue receipts leading to recession.
This cash crunch phenomenon is capable of causing a business cycle all by itself. During a downturn, large amount of unplanned income of capitalists lies in the vaults of the banks waiting to be invested. For a cheap interest rate, households have access to all of this cash. Households can therefore spend much in excess of what they earn. When households spend much in excess of what they earn, firms suddenly wake up to some big unexpected profits. This galvanizes them into action – they hire new workers, make plans for new investments and the economic activity picks up. Then as the economic activity accelerates, firms use up more and more of their unplanned income reserves slowly leading to a situation of cash crunch after a few years. As cash crunch builds up, short-term interests rise and so does inflation. Short-term yields start rising finally ending up with an inverted yield curve. Inverted yield curve is an indication of the extent of liquidity crunch in the system. As cash crunch builds up, something reverse happens. At the start of the boom, households dig into the unplanned incomes of the firms which is what has started the boom. Now something reverse happens – with the cash crunch building up, firms dig into the unplanned incomes of the households. This leads to a decline in household consumption and finally leads to a recession. Once again the unplanned incomes are built up and the cycle repeats itself.
Something similar has been taking place during the 80s and 90s. The peculiarity of IT investments is that the investor never needs to hurry. If an investor waits for another 3 months, he might get better software of the next release with more advanced hardware. In 1994, an IT investor would have thought – if I wait for another year, I might get windows 95, so let me wait. This way IT investments take on a slow and steady speed as compared to other types of investments. So there would always be huge unplanned incomes of the corporates in the bank vaults waiting to be invested at a slow and steady pace. As a result, during the 80s and 90s, given the nature of IT investments, there would be huge unplanned income resources lying in bank vaults waiting to be invested. Huge unplanned incomes depress short-term rates and a lot of cheap cash becomes available to households for consumption. Households then make use of this cheap cash and keep spending in excess of their incomes. The money that is spent in excess of their incomes turns into a handsome profit for the firms. This is how booms were financed in US and industrial nations during the 80s and 90s. Meanwhile households, in financing this consumption led boom, kept piling up trillions of dollars of debt. Even if we set aside the nature of IT investments, the economies of US and other industrial nations are maturing and there are no readily available investment opportunities where profits can be immediately invested. These profits sit in the bank vaults and become the source of huge levels of unplanned income depressing the short-term interest rates to historical lows thereby propelling borrowed consumption.
Apart from the phenomenon of inverted yield curves, we get an important insight from the above discussion. I believe that we have to compulsorily tolerate certain levels of inflation in a growing economy. This is because trying to accurately match money supply growth to product supply growth can lead to situations where, because of the cash crunch, firms can borrow into household incomes on a frequent basis leading to frequent disruptions in the circular flow of money in the economy creating chaos while resulting in repeated recessions. The only way to avoid firms and households stepping on each others toes would be to have a money supply growth that is faster than product supply growth – the extent of the difference being proportional to the growth rate of the economy. This would definitely lead to inflation but inflation is more tolerable than having the economy break up frequently. So if you had been thinking that inflation is purely because of irresponsibility of banks and governments, you would have to give it a second thought.
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