Inverse yield curve

The Malta Independent on Sunday

 

For the non-financial sophisticate, inverse yield curve occurs when the interest rate on long-term deposits is lower than interest rate applicable for similar deposit for a shorter term.

This goes against normal logic, which should suggest that the longer the term of the deposit, the higher the applicable rate should be, firstly to reward the depositor for opting to give up the privilege to make use of the deposited funds for a long period of time, and secondly to pay a premium for potential future rise in inflation that cannot be foreseen with any degree of confidence for any long term period.

In America we are close to an inverse yield curve situation for US dollar interest rates. A one-year deposit in US dollar currently pays 4.72 per cent, a five-year deposit pays 4.715 per cent and a 10-year deposit pays 4.805 per cent. Not quite an inverse curve but certainly a flat line curve and the risk of moving to an inverse yield curve situation has been the main topic of discussion in economic circles.

The concern about having an inverse yield curve is that economic history shows that it is a harbinger of bad economic tidings. Past history shows that on many occasions where the interest rate scenario produced an inverse yield curve, the general economy was on the verge of a recession. The reasoning goes like this. If long-term contracts are paying lower interest than shorter contracts, then it means that for the long term it is planned that short term interests would drop. After all, the long term is made up of a succession of short terms so if the long term rate is lower than the present short-term rate it means that future short-term rates are expected to fall.

Falling short-term rates are synonymous with a weakening economy, as monetary authorities tend to reduce short-term interest rates when the economy slows down creating spare capacity and falling inflation.

The conundrum this time is that the prospect of an inverse yield curve for interest rates on the US dollar comes with a background of strong economic data, which does not in any way suggest that any recession is round the corner even though one could well expect a slowdown in the aggressive rate of four per cent p.a. growth registered these last two years.

So the talk among economists and financial analysts observing the American economy has been whether an inverse yield curve in the current economic scenario still has the meaning it used to have in the past. One of the influential people who expressed himself on the matter was Alan Greenspan, the outgoing long serving chairman of the Federal Reserve Bank, who opined that it is very doubtful whether this time round an inverse yield curve should be taken to mean what it used to mean.

If this is so then the next question is obvious. Why is it that an inverse yield curve for interest rates no longer is a credible indicator of an impending recession? And the debate rages on, with million reasons to explain the interest rate mystery that saw overnight rates in the US raised from one per cent in June 2004 to the present 4.5 per cent while in the same period the 10-year rates for US treasuries dropped from 4.7 per cent to 4.4 per cent.

Having heard all the arguments I think this new phenomenon is the combined result of three main influences, which happened to coincide at the same time to nullify and reverse normal patterns of economic behaviour.

Firstly, it is that interest rate increases in the short term end of the curve have begun from a very low level of one per cent, and this after a time when we were seriously concerned about the risk of the US economy falling into a Japanese style price deflation. It is quite one thing having short-term interest rates at 20 per cent, like we experienced in 1982, and quite another having short-term interest rates peaking anywhere between 4.5 per cent and five per cent. High short-term interest rates by themselves act as a self-fulfilling prophecy in destroying demand and real asset values. So in such cases it is not the inverse yield that brings about a recession but the high short term rates which condition consumers to save rather than consume and makes borrowing for business, for investment or for home-mortgage prohibitively expensive.

This time, short-term rates have peaked at a rather low level and presented neither a disincentive for consumer demand nor a destroyer of asset values. Real estate prices and equity values continue their upward march all over the world.

The second reason why it is different this time is that we have excessive world liquidity that creates demand for long term financial instruments so that borrowers find easy takers for their bonds without have to pay high interest rates. This is probably the result of globalisation, which is producing sharp imbalances in balance of payments. Eastern countries in general and China in particular are building huge USD surpluses, which they are re-investing in US, money and capital markets. In a normal economy these surpluses would be spent on consumption of goods and services as citizens of surplus countries use their new-found wealth to raise their standard of living, including travelling to other countries to see the world. In case of China their economic system filters the surpluses to ensure that they continue to serve the collective needs of the State rather than cascade down to individual consumers. This in itself distorts the mechanism to regularise the structural imbalances and is creating excess liquidity ready to finance deficit countries at low rates.

The third reason is that world Central Banks have, since the inflation of the seventies and the recession of the eighties, made a rather good job of stabilising world economies and ironing out structural inflation, so much so that not even oil at USD 70 seems to present a threat to rising inflation. So if consumers have faith that short term interest rate increases serve to pre-empt the formation of long term inflation they do not need to demand high interest rates for their long term deposits knowing that inflation will remain controlled.

So many things these days do no longer mean what they used to mean. Globalisation and technology are changing everything.