The yield curve refers to the interest rates on bonds of varying
maturity. Normally, we expect the yield on bonds with longer maturities
to have a higher yield than those of shorter maturity bonds. Because it
is less of a burden to tie up one's money for three months or a year,
rather than five years or ten years, investors must be given an
incentive to place their funds in bonds of longer maturity. This
incentive takes the form of a higher interest rate paid on bonds with
longer duration. Similarly, we can justify the higher yields on longer
maturity bonds based on risk: the foreseeable risk to the economy over
the next three-months or year is much less than the risk over five or
ten years. Thus the higher yield on long-dated bonds is required to
compensate for the added risk of holding an investment that long.
On
December 30, 2005, many newspapers heralded the fact that the yield
curve on U.S. government bonds had become inverted. In fact, the curve
was not conshstently inverted. The yield on two-year Treasury notes
(just under 4.4%) barely exceeded the yield on ten-year Treasury notes
(4.39%). Ordinarily, this type of yield structure will be a
self-correcting problems. Investors will no longer choose ten-year
bonds, when they can get the same interest rate or even a higher one on
two-year bonds. With fewer people wanting to hold ten-year bonds, the
interest rates will rise on these in order to clear the market and
induce investors to hold ten-year bonds once again.
But when
long-term interest rates rise, so too do rates on 15-year and 30-year
residential mortgages. If the costs of obtaining a mortgage loan rise,
then fewer people will want to buy houses. The result could be either a
cooling of the previously hot real estate market, or a potential
collapse of some regional price bubbles on real estate.
If
inverted yield curves were merely a transitory phenomenon with little or
no economic impact, except for people in the business of trading
interest rate derivatives, swaps, and bonds; then no one would worry.
However, inverted yield curves have often signaled a recession will
follow, and the potential for a recession is a legitimate cause for
worry.
It would take more than one sign of an impending recession
before most economists would start to worry. At the start of 2006,
American businesses are expected to increase investments on capital
equipment, which should be a boost to the economy. The major cause for
concern is the seemingly ever rising foreign trade deficit. Americans
consume more than they produce and make up for the difference with
imports. Foreign businesses that sell goods to America often invest the
proceeds in U.S. government bonds. Because so many of our imported goods
are produced in China, the U.S. now has a significant portion of its
long term government bonds held by Chinese investors. The U.S. faces
political risk that the Chinese investors may one day decide to cut back
on their dollar holdings and place their cash in some other
government's bonds.
