$tarrBuck Report for September 24, 2006: Inverted Yield Curve?

                                September 24, 2006

$tarrBuck Report for September 24, 2006: Inverted Yield Curve?

by R. M. Starr
Stacey:  You know darling, a lot of our clients at Dewey Cheatam and Howe LLP are financial professionals: bankers, brokers, CFO’s.   They’re worried about the inverted yield curve.

Richard:  The inverted yield curve?   Well that’s definitely something to worry about.

Stacey:  Yeah, they think it leads to depression.

Richard:  Well if I were a banker, I’d be depressed too.   But in med school we’re still working on internal medicine.  We haven’t got to the behavioral medicine segment yet.

Stacey:  You really haven’t been listening to me at all.

Richard:  Yes, I have.   We’re talking about depression.  It’s a significant medical problem.

Stacey:  No we’re talking about the inverted yield curve.

Richard:  Well those guys must be in to some kinky things.  Inverted yields.  They must be really frustrated.  If they’re that kinky I guess that could lead to depression.

Stacey:  Darling!!!  Inverted yields is all about interest rates on government bonds.  It’s all about money.  It has nothing to do with kinky!!  What are you thinking about?

Richard:  Let’s try that again.  Interest rates on government bonds?

Stacey:  When the interest rate on short term government debt is higher than on long term government debt, then they say the yield curve is inverted — they mean it’s upside down from the way it usually works.  Usually long term debt carries a higher interest rate than short term debt.  The bankers worry that the upside down shape means that there’s an economic recession coming.

Richard:  Why are the bankers worried?  They’ve got lots of money.  Anyway, who cares what shape their curves are in?  There are lots more important curves to worry about;  we’re doing the GI tract in school now.  Those are important curves — get those wrong and you have a really bad tummy ache.

Stacey:  Yeah.  You’re right. Maybe it’s time for you to really crack the books.

The interest rate on short term government debt is pretty much set by the US Federal Reserve System’s Federal Open Market Committee (FOMC).   The FOMC tries to set interest rates to moderate economic growth and inflation.  The FOMC raises the short term interest rate when they think inflation is too high or they expect it to increase.  The FOMC reduces the short term rate when they think economic growth is too low or will be slower in the future.  The FOMC tries to adjust the short term interest rate to maintain a low predictable rate of inflation and sustainable economic growth.

Interest rates on longer term government debt — maturities from one year to thirty — are the result of the supply and demand for government bonds in the bond market.  Long term interest rates respond to how investors expect short term interest rates to move in the future.  There’s always a competition for investors’ money between short term and long term debt.

When investors expect the interest rate on short term government debt to be higher in the future, then they think it’s more profitable to hold short term debt now and roll it over into the next generation of short term debt in the future.  Then they’ll need a premium on long term interest rates now to lock up their money in long term debt.  Expecting an increase in the short term interest rate drives long term rates higher.

When investors expect the short term rate to move down in the future they’ll accept a lower interest rate now on long term bonds.   They can lock in the current yields and not have to worry about rolling over their investment in the future.  Usually long term interest rates are a bit higher than the short term rate, to compensate investors for locking up their money for a long time.   The way interest rates differ by the maturity of debt is what financial professionals call the yield curve.  Usually it’s upward sloping — longer maturities call for slightly higher yields.

Right now, the yield curve is inverted — upside down.  The interest rate on short term government debt is higher than on long term debt.  Three-month and six-month debt is yielding 5.0%.   Ten-year debt is yielding 4.6% .  What does that tell us about investor expectations?

Investors expect short-term interest rates to go down.   Rather than invest at 5.0% per year now, many are choosing to invest for ten years at 4.6% a year.  That means they expect the short term rate in the future to be lower than 5.0% .  They expect the FOMC to reduce the short-term rate, and reasonably soon.  That means they expect lower inflation, slower economic growth or a recession.  That’s what will induce the FOMC reduce the short term rate in the future.

So that’s why Stacey’s banker clients are worried.  But it’s their job to worry.  Is there an economic recession coming soon?  Could be.  But probably not.  If the FOMC is successful, it’s only that the inflation rate is coming down.  Enough so that the FOMC can reduce the short term interest rate in the future.

(c) R. M. Starr 2006

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