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Strategies & Market Trends : Mish's Global Economic Trend Analysis -- Ignore unavailable to you. Want to Upgrade?

To: Crimson Ghost who wrote (24463)	2/26/2005 12:21:02 PM
From: mishedlo	Read Replies (1) \| Respond to of 116555

That Tricky Yield Curve Will it continue to flatten? The Federal Reserve keeps pushing up short rates; bond bulls keep pushing down long yields. Trouble ahead. Borrowing short and lending long must be the second most lucrative industry in America, right behind printing dollar bills. A banker borrows short when he issues a 30-day certificate of deposit. He lends long when he writes a multiyear auto loan. Thrifts, mortgage REITs, hedge funds, finance companies and the federally sponsored mortgage behemoths all engage in this ancient gambit. Why wouldn't they? Short-term interest rates remain well below long-term rates. But the gulf between the two is closing--and therein lies the trouble. A year ago the short-term borrowing rate was 1%; today it's 2.5%. A year ago the five-year Treasury yield was 3.12%; today it's 3.78%. A year ago, in other words, there were 2.12 percentage points of daylight between the cost of an overnight loan and the yield on a five-year investment; today there's only 1.28 percentage points. The less daylight, the less profitable are the banking business and allied financial trades. Following is a speculation on who is at risk, and why. "Yield curve" is the term to describe the alignment of interest rates over time. The most crowd-pleasing alignment is that of short rates set comfortably below long rates (the curve is "positively sloped"). The least favorite is that of short rates higher than long rates (the curve is "inverted"). Also undesirable: short rates approximating long rates (the curve is "flat"). A flat or inverted curve stymies the business of lending and borrowing. It's ice on the wings of the U.S. financial economy. Just to look at the curve today, you wouldn't suppose there's anything wrong. What's wrong is the direction of change. The Federal Reserve is pushing up the funds rate while the market is pushing down rates on longer-dated fixed-income investments--Treasurys, corporates and mortgages. Mortgages present a particular problem. When interest rates get low enough, homeowners refinance: They pay down their loans at 100 cents on the dollar. The lender who paid, say, 105 cents on the dollar to buy his mortgages is immediately out of pocket one nickel per dollar of cost. Just as bad, he must redeploy his capital at the new, lower yields. Will the yield curve continue to flatten? The Fed has given no sign it intends to pull back from its campaign to restore the funds rate to something like 3.5% or 4%. And the yield pigs have given no sign that they intend to refrain from gulping down any and every piece of paper on offer. If I am right about the bond market, long-dated yields will sooner or later rise. Inflation or credit difficulties--or both--will push them up. And if they take off sooner rather than later, the curve may regain its former positive slope. "If" is the operative word. We are dealing with probabilities and risks. In an economy as leveraged as this one, the risk of a flat or inverted curve commands our respect. A flat curve would likely flatten--among others--mortgage investors. Their funding costs would rise. And if at the same time mortgage rates fell, touching off another wave of refinancings, the investors' interest income would fall. I am a long-term bull on Annaly Mortgage Management (19, NLY), currently yielding 10%. But if the curve flattened or inverted, the Annaly dividend would certainly be cut and the share price would probably fall. At least Annaly borrows in the capital markets. But mortgage-holding institutions like Commerce Bancorp (59, CBH), North Fork Bancorp (29, NFB) and Washington Mutual (42, WM) fund themselves in large part with deposits. And they've been busily building branches to gather them. The branches cost money, of course. But, so the banks reasoned, the money was well spent because deposits cost next to nothing. Or did. As the funds rate has risen, so have short-term deposit rates. Whether or not the curve literally flattens, competition for funds is plainly on the rise. Money market mutual funds--remember them?--currently yield 1.75%, "on their way to 2%," observes Peter Crane, vice president and managing editor ofI moneynet. The average bank money market deposit rate is just a hair over 1%. The venturesome readers of FORBES would naturally like to implement the appropriate trade. A speculative few may choose to sell short the financial institutions put at risk by a flattening curve. For the vast majority I advise holding an asset that, though almost universally reviled today, will surely be prized tomorrow. It pays a low but fast-rising return, and has a sexy four-letter ticker: CASH. James Grant is the editor of Grant's Interest Rate Observer. Visit his homepage at www.forbes.com/grant. forbes.com