Special Analysis: Of Crystal Balls and Yield Curves

The recent upsurge in stock prices has given many in the mainstream media cause for celebration, appearing as it does to be a sign of a strengthening and healthy economy. Implicitly, the message is that the neo-conservative economics of massive federal budget deficits caused by round after round of tax cuts coupled with a war of opportunity have created a growth environment. Aside from the minor annoyance, largely if not entirely downplayed by the mainstream news media, of an official unemployment rate that has remained persistently above a historically high five percent, the good times seem to be just about unstoppable.

The only cloud on the horizon seems to be the Federal Reserve Board, which last year declared an end to its "accommodative policy" of printing money to finance the Republicans' excesses of spending beyond tax revenues. The Federal Reserve did this because, if the money supply grows faster than the real growth rate of the economy, the result will be inflation. Since early in the Bush Administration, the Federal Reserve had been more than a little helpful to the radical Republican agenda; and it is in part a tribute to the two decades of low inflation before the 21^st Century that markets did not react before now to the growing overhang of dollars that were filling the economy for Mr. Bush and the neo-cons. But recent, modest increases in the consumer price index and the producer price index pointed last year to growing inflationary pressures, and so the Fed began to tighten the money supply using its available tools.

How to Be a Central Bank
The price of money is interest rates. If the supply of money becomes relatively more restricted, its price will rise. That means the Fed's contractionary monetary policy will cause interest rates in the economy to go up. However, the Fed has direct control only over short-term interest rates: it sets two key rates, and it directly manipulates the very important yield on short-term government debt obligations. The way it does this second exercise is by using Treasury bills (short-term government debt obligations) as trading instruments with banks. When the Fed wants more money in the economy, it buys Treasury bills held by banks: the Fed pays the banks with cash money, so the money supply in the banking system expands. On the other hand, if the Fed wants to drain liquidity out of the banking system, it sells Treasury bills to banks: the banks pay cash money to the Fed for those T-bills, and that means less money in the banking system. These buying and selling exercises are called "open market operations," and they're done every day. These OMOs are the primary means by which monetary policy is operationalized.

So the central bank of the United States of America is right now carefully draining liquidity out of the economy to the end of giving the economy, through its growth, an opportunity to absorb the overhang of greenbacks. The danger is that, if interest rates rise too much and too fast, the economy will suffer: businesses will stop borrowing to expand operations, consumers will stop borrowing to buy big ticket items, households will start putting too much money in savings accounts instead of buying stuff, and the American dollar will become so strong overseas that no people in other countries will be able to afford our exports. It, therefore, is a balancing act for the Fed: contract the money supply too slowly, and the inflationary pressures continue to build; contract the money supply too quickly, and interest rates rise too much and too swiftly for the economy's participants to adapt without creating a recession. Everyone of good will hopes that the central bank can do what it must, but at the same time do so with judicious caution. To stop the inflation before it becomes embedded in wage and price expectations, the Fed is now going about what should have been its sole mission all along: "ensuring the stability of the aggregate price level," which is technical terminology for keeping inflations and deflations from ever happening.

Recall above that the Fed controls only the short-term interest rates in an economy. It sets the largely symbolic "discount rate" at which it would lend money to a bank; and it sets the "Federal Funds rate," the rate at which banks may lend money to one another. Far more importantly, though, through its open market operations, the Fed sets the rate on short-term Treasury bills, those highly liquid, short-term instruments used by the federal government to borrow billions of dollars in quick cash. When the Fed buys these securities from banks, that means the demand for them is increasing, which drives their price up. On the other hand, when the Fed sells these Treasury securities to banks, that means the supply of them in the banking system is surging, which causes their price to drop.

Now, here's the part that can confuse people who aren't familiar with finance: when the price of a bond goes up, its yield falls; and when the price of a bond goes down, its yield rises. This isn't some theory; it's just a mathematical fact, and following are two examples to show it. Keep in mind that a one-year Treasury bill is bought at some price less than a thousand dollars, and in one year, the T-bill matures and the investor is paid exactly a thousand dollars.

Let's say the price of the T-bill is $970. That means an investor pays $970 now, and gets $1000 in a year. Hence, an investment of $970 earns $30 in interest, so the yield on the investment is $30÷&970, or about 3.09%.

Now let's say the price of the T-bill falls to $960. That means an investor pays $960 now, and gets $1000 in a year. Hence, an investment of $960 earns $40 in interest, so the yield on the investment is $40÷$960, or about 4.17%.

There it is: a bond price of $970 means a yield of 3.09%, but a bond price of $960 means a yield of 4.17%! As prices of bonds fall, their yields rise, and as prices of bonds rise, their yields fall.

When Yield Curves Misbehave
Now comes the part about what's going on in the American economy today. The Fed is selling lots of T-bills to banks. This drains liquidity from the banking system, which drives interest rates up. At the same time, because the Fed is increasing the supply of short-term Treasury instruments in the banking system, the price of T-bills is dropping, so this is pushing the yields on those T-bills upward.

In an ideal world, as short-term rates—the ones the Federal Reserve can control through its operations—go up, long-term yields and rates should march up pretty much in lock-step, since long-term rates should have the short-term rates embedded in them, along with some extra points for longer and longer commitments of the money. In other words, in an ideal world, the so-called "yield curve"—the graph of yields on various maturities of Treasury securities against their terms to maturity—should be a gently rising arc, starting at the yields on short-term T-bills, and rising fairly smoothly upward to mark the yields of the intermediate-term Treasury "notes" and on outward to the truly long-term Treasury "bonds." At right are recent snapshots of the yield curve. Each one of them, taken by itself, is not unusual on its face: each one has the classic, upward arc of a normal yield curve. The troubling part is what the yield curves look like taken all together because the long-term yields having been quite noticeably dropping, which could happen only if the prices of those long-term instruments were rising. The problem is that the United States government is borrowing billions and billions of dollars, which means the Treasury Department is selling stadiums full of long-term T-bonds. With the supply of T-bonds hammering upward, the price of T-bonds should be falling, which means the yields on T-bonds should be rising. But right there are those yield curves, and there is no mistaking it: the yields are not rising; they're falling. Something is causing the prices of Treasury bonds to keep rising, thereby pushing down the long end of the yield curve. So who's doing this? Investors.

Domestic and foreign investors are buying out on the long end of the government's debt securities; and they're getting the money to do this from several likely sources. Foreign investors are using the greenbacks they've earned from selling cheap stuff to Americans; and domestic investors are getting the money from bailing out of the short end of the yield curve. The recent surge in stock prices has been some of those same proceeds being thrown into equities, which are in some respects nothing but infinitely long-maturity debt obligations, anyway.

Now, there's nothing wrong with this. It's a little weird to see the yield curve flattening, but it's not a disaster. Unless...

Unless What?!
If the long end of the yield curve goes below the short end of it, the result is called an "inverted yield curve"; and it's a fairly rare animal. More importantly though, sometimes—not always, but sometimes—inverted yield curves precede recessions.

In fact, five recent recessions have been preceded by inverted yield curves. Count 'em: five.

Looking once again at that yield curve as of yesterday, it is obvious that the thing isn't inverted. And it might very well be the case that it never will get to a full inversion. And even if it does get to a full inversion, that certainly doesn't prove that a recession will occur: the yield curve has briefly inverted in the past, and the economy has subsequently dodged a serious downturn.

In other words, it's not something to get worried about. Certainly not yet, anyway.




The Dark Wraith encourages all of you to have a bright and hopeful day.