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Pol/Econ Currency
Pol/Econ: US Interest Rate Yield Curve Inverts: Apocalypse at 11
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Wednesday, 28 December 2005 Written by Alexander G. Rubio

Outgoing Fed Chairman
Alan Greenspan
Yesterday a low dry ominous rumble was heard over the far off hills of the financial markets. For the first time, since it presaged the 2000 market collapse, we saw an inverted yield curve, that is, the short-term interest rates were higher than long-term interest rates. The yield on US Treasury bills with a two year maturity yesterday stood at 4,347%, while the ten year bills yielded 4,343%. This has historically been an omen of bad things financially speaking.

Now for obvious reasons this took place during very thin trading, so it's hard to know how much to read into this. In addition the yield curve has inverted before without the horsemen of the Apocalypse falling on an unsuspecting populace, for example in 1996, just before the dot.com cauldron really got to a bubble. Some people though, your's truly included, feel that this correction was headed off by Chairman of The Federal Reserve, Alan Greenspan, by injecting excess liquidity into the market, and thus setting the stage for later, and greater, imbalances and dislocations.

Now the question is, was that sound merely a blip, wood cracking and splitting in the winter cold? Or was it hooves impatiently striking the pavement stones, rearing to go? And if the latter is the case, can the horsemen somehow, once again, be bribed to forgo this round?


Fed Chair in waiting
Ben Bernanke
Before moving on, a more substantial explanation of the yield curve might be in order. If you lend someone reputable a sum of money over a short period of time, say a year or two, you'd feel rather safe that he or she wouldn't go belly up during that time and default on the loan. The risk is low. So the interest rate you'd want for taking that risk would likewise be rather low.

If, on the other hand, the person, or institution, in need of the loan wanted that sum for ten years, you're headed into the murky waters of fortune telling, tea leaves and all manner of things that can go terribly wrong. The risk of losing the money is higher, and so, under normal circumstances, should the interest rate be. In addition to this, inflation is always eating away at the value of the loan. The interest rate you charge should ideally keep you ahead of this erosion of your investment. If people smell higher inflation in the air, they're likely to sell off long term bonds, driving the price down and the yield up.

A steep yield curve is a bullish signal for stock investors. Investors may be switching out of bonds into equities, causing long-term yields to rise, or the Fed may be driving down short-term interest rates to stimulate the economy. When the situation reverses, or inverts, it suggests that bond investors expect interest rates to fall, a trend usually associated with weak growth and low inflation. The past six US recessions have been preceded by an inversion of the yield curve

The Federal Reserve has been raising the short term rates it charges on its short term bonds for the last 13 months, a move usually employed to counter rising inflation. But official inflation numbers have been rather tame lately, despite strong growth, however dubious, in the economy.

While the Federal Reserve short term interest rate was kept very low, some would say artificially low seeing as it was at or below the rate of inflation, financial actors indulging in what is called "carry trade", that is they borrowed at low short term rates, and lent it out at higher long term ones. A rather substantial sum of money has been tied up in this trade. You can probably spot the risk inherent in this particular play as the yield curve inverts.

Outgoing Federal Reserve Board Chairman Alan Greenspan, along with Chair in waiting Ben Bernanke and many high profile economists and analysts point to the couple of cases in recent economic history where an inversion of the yield curve did not precede an economic downturn, and what they claim is a radically different and more flexible economy, to bolster their case for even a protracted and intensified inverted yield curve not signaling any major slowdown in the economy.

Myself, I think I'll pop "Apocalypse Now" in the player and watch people blowing stuff up while stoned to their eyeballs. You know, just to acclimatise myself, and to keep the Christmas cheer going.



This article is also available at The Booman Tribune and Daily Kos.