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By James Pini
Yield curves have been an extremely difficult economic phenomenon for economists to explain. But during 2011, there has been much talk of them and their importance for suggesting future economic conditions.
The yield curve, when seen at one point in time, is a measure of interest rates on securities of different maturities. It typically has a positive slope, meaning that the longer the maturity, the greater the annual return investors demand. This makes sense in that the longer an investor is locking in a particular return, the greater chance “something might go wrong,” which would cause him to demand more return up front.
The yield curve can also be seen through time. Here, as can be seen in the chart below, two particular rates are graphed through time. When the shorter maturity rate rises above the longer maturity rate, it can be said that the curve is “inverted.” Unlike during the normal yield curve, investors are willing to accept a smaller return on longer maturities.
Having a good understanding of the yield curve is important because of this fact: The U.S. yield curve has inverted eight times since 1960; in seven of them a recession has occurred soon after. The only false-signal was in the mid-sixties, and although there wasn’t a recession, the economy slowed. Conversely, every recession has been preceded by an inverted yield curve.
One might explain this phenomenon in two different ways. One is that by the central bank raising short-term rates through monetary policy, it forces banks to restrict their lending since they typically “borrow short and lend long.” (If short term rates are greater than long term rates, banks have no profit margin). This in turn slows the economy. Under this explanation, an inverted yield curve causes recessions.
Another explanation is that an inverted yield curve is indicative of a change in investor expectations. The basis of this idea is that longer-term rates are a function of expected future short-term rates. Hence, when the market expects a recession, they also expect the central bank to lower interest rates in the future, so investors are willing to accept lower long-term rates.
Today, there is again talk of another potential recession. But those who looked to the inverted U.S. yield curve back in 2006 to predict the 2008 downturn can’t do the same again; the Fed is very unlikely to let short-term rates rise, as the overnight lending rate is supposed to stay low until at least mid-2013, not to mention that QE III appears to be just around the corner as well.
Instead, many are looking toward the yield curves of countries like Brazil, Russia, India, China, New Zealand, Norway, Chile and other growing economies that presently have more conventional monetary policies. Some of those countries inverted earlier in the year, some of them still are, and some of them might invert soon.
The question is whether these inversions are as strong an indicator as they have been in the U.S. For example, for many of these countries (e.g. China, Russia, Brazil), the bond markets do not exactly have as long and as stable a history that the U.S. does. In other words, even if there is an inverted yield curve in China, there’s no way to calculate how probable a recession is.
Despite all this, these countries are being closing watched by many investors, and it would be prudent for all of us to pay some attention.
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“they find that real isterent rates in advanced economies were negative about half the time between 1945 and 1980, and ‘for the United States and the United Kingdom, the annual liquidation of debt via negative real isterent rates amounted to 3 to 4 percent of GDP on average per year.”This implies that long-term holders of government debt are mugs at least half the time! It’s almost as if savers are providing some sort of social service to the economy especially in the UK/US case.