US Treasury yield curve inverts
As long predicted, the US treasure yield curve, has inverted:
http://money.cnn.com/2005/12/27/markets/bondcenter/treasury_yields.reut/index.htm
For those not familiar with what the yield curve is or can signify, heres a brief intro. The treasure yield curve is a graph of the various bonds and their yields over time. So, a 1 year bond might yield 2% while a 30 year bond 5%. Why is it a curve and not flat? First, its important to know how these rates are set. The shortest term rate is called the Federal Funds rate and is set by the Federal Reserve board, which Alan Greenspan has been on for over 20 years. Long term rates are traded, like stocks, and the interest rates fluctuate and represent what “the market” believe is the correct value. Say oil prices go up: likely interest rates will be bid up in the believe that things will be more expensive in the future.
And it is because the future is not known that lending over a longer term adds more uncertainty and risk. Interest rates often are a representation of risk - compare the interest rate you receive from a FDIC bank(which is low since you are guaranteed to not lose your money) against the high interest rate you receive on junk bonds, debt from companies often boarding on going bankrupt.
So we expect a curve over time, and the “steeper” the curve, the more optimistic people are about the future. Why? Because long term interest rates represent what people are betting the short term rates will be at some point in the future. And if a 1 year bond is 2%, while the 5 year bond is 5%, it means that in 5 years people think a 1 year bond will pay 5%. While runaway inflation can be a cause of a steep yield curve - and is bad - the most common reason for it is economic growth and the expansion of the economy which is good for just about everything and everyone.
What does an inverted yield curve mean? Beyond the basic statement that it means people think interest rates will be lower in the future, in general this represents a negative view of the future. The simplest explanation is that people believe the economy will slow down and require the FED to lower interest rates. Lower interest rates stoke the fire that is capitalism and encourage people to borrow more to create new businesses and to save less, meaning they likely spend more which helps the economy. So in general, an inverted yield curve can, and often does, signify a recession. The curve inverted in 2000, and 1989, but its not a cause of a recession.
At the beginning of this article I noted this event has been “long predicted”. This is because the fed has broadcast what its actions would be for the last 12 months and since they have raised interest rates by .25% each time, one could easily calculate when this would occur. The odd thing is of course that no one seems to be listening to them. Because, if you know interest rates will be higher in the future, why buy bonds now? Or why not buy short term bonds?
Well, if youre a large government flush with too many dollars you don’t really have a choice. Countries like China are sitting on huge bundles of dollars and not sure what to do with them. If they exchanged the dollars into their own currency, the Yuan, they would effect the exchange rate causing the Yuan to increase versus the dollar, making the price of goods they export go up? And what would Walmart do if that happened? They might go find some other country like Vietnam to build factories. China right now needs factories and jobs for people. So instead, they buy US Treasures not particularly concerned about a possible loss since they have gained so much with foreign investment.
This is the end of part one which has discussed what has brought is to the tipping point, and part two will discuss what will likely happen from here and its implications.
Happy new years to everyone!
Technorati Tags: Politics and Economics