When the TV weather forecasters report a temperature inversion, they are talking about a situation that is essentially upside down.
In the climate in which we live, warm air tends to rise into the atmosphere. This movement generates air circulation in the form of surface and low-altitude winds. In a temperature inversion, though, the air near the surface gets trapped by a layer of warmer air above it and nothing moves. There is little or no circulation. Air pollution, burn bans and other bad things soon follow.
In economics, an interest rate inversion is also a situation that is upside down. Normally, interest rates rise with the length of time that the investor’s money is tied up. It is called the risk premium.
This makes a lot of sense, really. The longer the time frame, the more likely it is that something could go wrong. We would expect, then, that short-term loans, or bonds, would have lower interest rates and long-term loans or bonds would have higher interest rates. And normally, we would be right.
Every once in a while, though, things turn upside down and we get what is called an inverted yield curve, which is a situation where long-term interest rates are lower than short-term rates.
It is called a yield curve instead of an interest rate curve because of the math that connects interest rates to bond prices. Bonds of widely different interest rates exist side-by-side in the market, and are priced accordingly. Yield is really the effective interest rate, or return to the investor.
Like a temperature inversion, the inverted yield curve’s portrayal of an upside down situation brings on worries about bad things to come. Inverted yield curves have preceded most of the recessions in recent U.S. history. And although it doesn’t always work out that way – there are more inverted yield curves than recessions – the upside-down interest rate situation they portray always gets the attention of investors and economic forecasters alike.
We have been enjoying, or enduring, an inverted yield curve since early 2006, and it has cause a considerable amount of anxiety. In his most recent “state of the economy” testimony before the Senate Banking Committee, Federal Reserve Chairman Ben Bernanke felt obliged to acknowledge the anxiety level but said that the inverted yield curve did not mean that a recession was headed our way. He said there was evidence that it was being caused by increased global liquidity and competition among U.S. banks for deposits.
With today’s electronic capital flows, it makes sense that that global liquidity is affecting our financial markets. As a result, the idea of a global yield curve is beginning to be a factor in analysts’ thinking, and it still appears to be normal – that is, higher interest rates for longer-term bonds.
Still, just how much comfort we should take in the explanations isn’t clear. Even if the inverted yield curve doesn’t signal a recession this time, it can still mess up a lot of things in our economy. An interest rate inversion is destabilizing, especially for financial institutions.
Pension funds and insurance companies, which are typically stable influences on our financial markets, now face a situation where the rate of return is higher for short-term investments than long-term. That is why pension funds, for example, have been putting a lot of money into hedge funds.
The interest rate inversion has also driven banks into the derivatives market to try to bridge the gap between what they pay in short-term deposit rates and their income from long-term loan rates.
There are two things wrong with this. First, the derivatives market is far too complex for fiduciaries such as banks (or anyone else, including bank regulators) to assess the actual risk of their positions. Second, the relatively new $26 trillion credit derivatives market – already twice the size of the entire U.S. economy – is an industry that’s used to small interest rate changes. It has never been tested by a market retrenchment, an interest rate spike, or even a substantial shift upward or downward in rates.
The experts, including Fed Chairman Bernanke, are probably right that the inverted yield curve we are experiencing now isn’t the same sort we worried about in the past. Still, as Igor put it in “Young Frankenstein,” it’s “Abby Normal” and it brings its own set of worrisome problems. Inverted yield curves, like temperature inversions, don’t always result in disasters. Still, I don’t know of anything good that ever came from either one of them.
James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101” monthly for the Snohomish County Business Journal.
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