LESSON #3: Inverted Yield Curve (Condensed
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An inverted yield curve is usually a sign that the market sees an economic slowdown looming...and in times past, this situation presaged a recession (except when the Fed created asset bubbles to ward it off).
Folks who think the Fed is going to lower interest rates to fight a recession rush to "lock in" long-term interest rates by buying (in this case) 10-year treasuries sending the yields lower. The bond's price and the yield are inversely related, so when folks "demand" more bonds, the price goes up and the yield goes down (or if they rush to unload them, the price goes down and the yield goes up -- same situation as stock prices and their dividends). Hold this thought for now.
This situation worked pretty well in the past, but here is the rub. Foreign countries are holding over $2.4 Trillion in US debt. The foreigners are feeding the US money so we can buy their oil to put in our SUVs, their plasma TVs and their plastic junk from the Dollar Trees. We take out HELOCs or use credit cards to buy their stuff, and most all of the money finds it way to Japan and China (the #1 & #2 holders of our debt) so they can pass it back to the US in return for treasuries where it ends up in banks for us to borrow so we can continue to buy their junk. Swell! But can you see the downside? Neither can the people who are in debt up to their eyeballs. And too much money chasing too few goods causes inflation--for those too young to know what this feels like, let's just say it blows!
The Fed would normally slow down the economy by increasing discount rates (the rates banks charge each other for overnight loans) which usually moves the prime lending rates higher. They want the citizens to stop spending like maniacs and put something into savings. Raising the rates is supposed to raise the long-term rates in tandem and make putting money into savings an attractive option. Unfortunately for Greenspan, it didn't work this time--he raised the rates in "measured" paces and too slowly so as not to upset the economy. The short-term rates increased, but the long-term rates held fast (the famous conundrum). Underestimating the greed of the nation, he kept going and going...people kept spending and spending. When mortgage rates got a little too high in one type of loan, they came up with other "exotic loans" to make the ever-increasing housing prices affordable to all the masses--"Don't worry about that 1-year ARM, you'll have this condo sold in the blink of an eye and have $50,000 profit with no risk at all--just sign here. GREAT! Psst...we've got another tower going up, how about a preconstruction--just take out an equity loan on your primary residence, you won't need to worry about a mortgage, when it's finished people will be lined up to throw money at you to take it off your hands....sign here."
Now the short-term yields are higher than the long-term yields (and the yield curve is inverted), foreigners are still buying up the US debt because they've got tons of US money laying around collecting dust to lend and 4%+ which is a pretty good deal. BUT...there is a problem, the housing market is toast and the businesses aren't picking up the economic slack like they were supposed to do. Corporations are FLUSH with cash from the economic boom, but instead of buying all sorts of capital goods and opening up new businesses to keep the economy humming along, they're using the cash to buy up their stocks, raising CEOs compensation and paying SEC fines. The market smells economic hard times are ahead--maybe a recession. The world is a troubled place and there is a flight to quality (read 10-year treasuries). At the same time, other central banks around the world are also starting to raise their interest rates as well.
What is the FED to do if there is a recession? Most people think that they'll ride to the rescue, as in the past, and lower interest rates and start the machine back up again. Now there is a problem though...globalization has happened. Foreign countries hold a good deal of their reserves in US dollars (our debt) and if they think the US is going to start dropping interest rates (which will cause their investments in US dollars to lose value) they will seriously consider diversifying out of US dollars and into other currencies (that pay higher interest) and/or into gold.
The US doesn't want them to do this, because if the likes of China starts "cashing in" its $639 Billion in US treasuries, the supply flooding the market will outstrip demand. And if we can't sell our future debt (which we use to pay off our current debt) we will be in worse shape...folks will demand ever higher yields which the US will be forced to pay or risk a default of US treasuries.
Now, do you remember the part of the lesson from above about the inverse relationship between the price and yield of bonds?--if China floods the markets with a slew of treasuries that outstrip demand...bond prices will drop like a rock, causing yields will soar (that inverse relationship) and the cost of borrowing money will skyrocket. If no one wants to buy our US debt because they can get better interest elsewhere, we've gotta raise the interest rates high enough to attract investors away from other bonds which will also cause the cost of borrowing money to skyrocket. So this is why the FED needs to walk a tightrope when considering lowering the interest rates again in the future. It's very different this time.
If people think "oh goody" the interest rates are dropping, so mortgage rates will drop and the real estate market will come roaring back bigger and better than ever...I'm here to say that it just isn't that easy. (IMO)
This is a really good thread. I have always made money by following my gut. I never really analyze or worry about it. I could never look at anything the way Shelley does. Nothing personal Shelley but I would have to lock myself away if I had all that info. I guess that is what makes the world go round. Your comments make you appear to be happy about others misfortune... I find that odd and probably a good thing you remain anonymous.
