The yield curve refers to the interest rates on bonds of varying
maturity. Normally, we expect the yield on bonds with longer
maturities to have a higher yield than those of shorter maturity
bonds. Because it is less of a burden to tie up one's money for
three months or a year, rather than five years or ten years,
investors must be given an incentive to place their funds in
bonds of longer maturity. This incentive takes the form of a
higher interest rate paid on bonds with longer duration.
Similarly, we can justify the higher yields on longer maturity
bonds based on risk: the foreseeable risk to the economy over
the next three-months or year is much less than the risk over
five or ten years. Thus the higher yield on long-dated bonds is
required to compensate for the added risk of holding an
investment that long.
On December 30, 2005, many newspapers heralded the fact that the
yield curve on U.S. government bonds had become inverted. In
fact, the curve was not consistently inverted. The yield on
two-year Treasury notes (just under 4.4%) barely exceeded the
yield on ten-year Treasury notes (4.39%). Ordinarily, this type
of yield structure will be a self-correcting problems. Investors
will no longer choose ten-year bonds, when they can get the same
interest rate or even a higher one on two-year bonds. With fewer
people wanting to hold ten-year bonds, the interest rates will
rise on these in order to clear the market and induce investors
to hold ten-year bonds once again.
But when long-term interest rates rise, so too do rates on
15-year and 30-year residential mortgages. If the costs of
obtaining a mortgage loan rise, then fewer people will want to
buy houses. The result could be either a cooling of the
previously hot real estate market, or a potential collapse of
some regional price bubbles on real estate.
If inverted yield curves were merely a transitory phenomenon
with little or no economic impact, except for people in the
business of trading interest rate derivatives, swaps, and bonds;
then no one would worry. However, inverted yield curves have
often signaled a recession will follow, and the potential for a
recession is a legitimate cause for worry.
It would take more than one sign of an impending recession
before most economists would start to worry. At the start of
2006, American businesses are expected to increase investments
on capital equipment, which should be a boost to the economy.
The major cause for concern is the seemingly ever rising foreign
trade deficit. Americans consume more than they produce and make
up for the difference with imports. Foreign businesses that sell
goods to America often invest the proceeds in U.S. government
bonds. Because so many of our imported goods are produced in
China, the U.S. now has a significant portion of its long term
government bonds held by Chinese investors. The U.S. faces
political risk that the Chinese investors may one day decide to
cut back on their dollar holdings and place their cash in some
other government's bonds.
An article published on Dec. 31, 2005, in the Financial Times
(London, England) noted "Each of the last six US recessions has
been preceded by an inverted yield curve, [but]. .. it has
sent out two "false positives," inverting in 1966 and 1998." As
noted above, with yields of 4.39% and approximately 4.40%, the
yield curve between two-year and ten-year is actually more flat
than inverted. For now, in the first week of January 2006, the
best course is to wait and see if the yield curve becomes more
inverted or reverts back to its normal shape. As a professional
economist, I will not begin to worry unless the yield curve
remains flat for over a month, or the inversion increases from
0.01% to 0.50%.
For additional articles by this author on financial economics,
please see
http://michaelguth.com/finecon.htm
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