Wednesday, June 13, 2018

Bond Bears Start to Worry

A couple of days ago the Wall Street Journal started to worry about the "inverted" yield curve. Go take a look.

What they are saying is that the recent interest rate increases have brought the 2-year Treasuries close to the 10-year Treasuries. Oh no!

So what is the current Treasury yield curve? I am glad you asked, because I am setting it up on my site.

This is called a "normal" yield curve. As you can see, the interest rate on a 1M -- or one month -- Treasury bill is less than, e.g., a 1Y -- or one year -- Treasury bill. In fact every longer maturity Treasury security has an interest rate higher than all the securities with a shorter maturity.

So everything looks fine. In that case what are the WSJ boys whining about? They are whining about this, the yield curve from late in 2006, at the very end of the 2000s expansion before the Great Crash of 2008.

That, my friends, is what an"inverted" yield curve looks like. In this case the short-term Treasury securities are yielding over 5 percent and the medium and long-term securities are yielding about 4.6 percent.

Why is this a problem? It is a problem because the business that almost all financial institutions are playing, banks especially, is to borrow short (i.e. checking accounts where depositors can remove money immediately) and to lend long (i.e., everything from car loans business loans to home mortgage loans).

When banks are borrowing at 5 percent and lending at 4.5 percent, then they are losing money. The result is a financial crisis.

Obviously we are not there yet, and the yield curve is still normal. But. The Federal Reserve is expected to be raising interest rates three or four times this year. That would bring short term rates from 2 percent to 3 percent. No doubt long-term rates would increase too.

The question is, how many interest rate hikes would it take before the short-term rates start to get bigger than the long-term rates.

That is the question.

But what do you care, if you have a mortgage already? You care because if you have to sell your home, the guy buying it will have to pay a much higher interest rate on his mortgage. And that will tend to lower the price that he can bid for your house.

For those of you with a yen for history, the current situation is similar to the late 1920s. President Coolidge, in association with his Treasury Secretary Andrew Mellon, lowered income tax rates again and again. It set off an amazing boom. In due course, of course, the Fed raised interest rates, and at some point, the stock market started retreating. Then the market crashed. And the political hacks at the Federal Reserve hesitated to act as lender of last resort when banks started failing.

Fast forward to 2008. In September 2008 Gentle Ben Bernanke hesitated to bail out Lehman Brothers. Then the Dow Jones Industrials started losing 500 points per day, every day.

I  wonder if current Fed Chairman Jerome Powell has the necessary cojones.

Just saying.

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