If you want to understand the Yield Curve inversion; this piece will do it copied from AHHAHAs thread in total;
From: ahhaha 5/23/2007 1:11:10 PM
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Grace referred to this Q&A that Greg Mankiw of Hahvahd penned:
Q: What is the yield curve, and what is an inverted yield curve?
A: The yield curve is graph of the interest rate on bonds as a function of time to maturity. Normally, long-term interest rates are higher than short-term interest rates to compensate for their greater riskiness, so the yield curve slopes upward. Sometimes, the situation reverses: short rates rise above long rates, and the yield curve is said to be inverted.
The first answer is actuarial, so how can the second part of his answer arise?
Q: Why would the yield curve ever invert?
A: The yield curve inverts when bond investors expect short-term interest rates to fall. They are willing to hold long-term bonds, despite the lower current yield, because they are locking in the yield. In other words, current long rates reflect both current short rates and expected future short rates. When investors expect a significant decline in short rates, long rates will be below current short rates.
The yield curve inverts relative to his above stated actuarial state when either demand for loanable funds pushes short rates above or FED marks them above. It is completely mistaken to characterize a fall of short rates below long as a yield curve inversion, and this is one source of this era's confusion about implications of yield curve inversion.
Such a drop has nothing to do with "willingness to hold long-term bonds", if only because the dynamic that sends short rates lower, is a dynamic which is temporally disconnected with yields on longer.
Proof that Mankiw has no clue is seen with his statement, "current long rates reflect both current short rates and expected future short rates". Expected future short rates? The expectation is zero, i.e., tomorrow's short rate is expected to equal today's. The short rate is governed either by instantaneous fluctuations in the money market or by FED meddling. In either case the outcome is random, and that provides the zero expectation.
But also, current long rates never reflect current short rates. They're independent even though one may think that if the two get far enough apart it makes sense to borrow one to buy/sell the other.
Moreover, his statement that "When investors expect a significant decline in short rates, long rates will be below current short rates.", is absurd. No one ever has an expectation for the short rate except instantaneously in response to say, FED market intervention, or locally in, say, fed funds futures trading. In this era FED thoroughly controls the short rate and that's a random determination. There's no way of knowing what FED will do because nothing they do is rational, but is a reaction to their cumulative ignorance. For example, FED created a negative real rate from 2001 to 2004 in order to fend off their imagined recession. AG didn't want to repeat the 1931 major mistake. During those years I looked high and low for a recession, but as I stated then on this thread, there was no one near, and FED's artificial rate did nothing but prop inflation.
Q: When would bond investors expect short rates to fall?
A: Remember that short rates are set by the Federal Reserve. So when the yield curve is inverted, investors expect the Fed to be loosening monetary policy.
How about in the usual, normal economic situation where inverted yield curve means short rate above long? FED forces the short rate above the long to cool demand for loanable funds. The only reason the US hasn't visited those shores is because foreign efficiency of employed capital and capital flows have rendered it moot. Mankiw's reply begs the question, or the answer, as it were. First, his answer implies that investors determine the short rate which contradicts the fact the FED solely determines that rate in this era, and then he implies that market expectations change and then FED changes the rate. That again contradicts the fact that FED solely determines the short rate regardless of market expectations.
Q: And why might they expect the Fed to be loosening?
A: Perhaps because they think that the economy is slowing. They expect the Fed would react to a slowdown with looser monetary policy in order to stimulate aggregate demand. As a result, the perception of an upcoming economic slowdown leads to an inverted yield curve today.
Notice how Mankiw is programmed by this era's world financial structure to characterize inverted yield curve in a way that's exactly opposite to the way it has been defined historically. Eventually, the world financial structure will achieve an international parity that will bring back the old regime.
That is why the slope of the yield curve is one of the variables in the index of leading indicators.
He was talking about inversion, total difference between two, not slope, instantaneous difference in one or the other.
Q: How well does the yield curve predict upcoming economic trends?
A: Pretty well, as compared with other indicators, but it is far from perfect. Remember that economic activity is only one thing the Fed looks at when setting interest rates. It also looks at inflation. So the yield curve also reflects investors' perception of inflation trends. And economic conditions have a great deal of instrinsic uncertainty, which makes even the best indicator far from perfectly reliable.
In fact, the long rate is exclusively determined by inflation expectations, and the short rate is determined exclusively by FED's intervention in an attempt to manage inflation. The difference between the two, the yield curve, therefore, represents the confusion on everyone's part about the level of incompetence at FED. FED shouldn't be too strongly blamed except on principle, since it's impossible to calculate the right short rate. Thus the yield curve status has no predictive power. |
