A quick note on the yield curve for Alex Balk

By Felix Salmon
May 13, 2009

Let’s say you have two apples. You’re scared of losing those apples, and you want to be sure that they’re absolutely safe. So you give them to the government, and in return the government promises to give you back two apples in a year’s time. You’re happy, and the government gets to eat your apples today, not worrying about paying you back until this time next year. So the government’s happy too. This is known as a “flat yield curve”, and it tends to happen when the economy is depressed and the general mood is rather grim.

Let’s say you have two apples. They’re delicious, and abundant, and you reckon that if you eat them now you’ll be full of vim and vigor and will have the wherewithal to find lots more apples if and when you need them in the future. So before you give the government your two apples today, the government needs to promise to give you back three apples in a year’s time. This is known as a “steep yield curve”, and it tends to happen when people are more optimistic about the future.

Caroline Baum says — rightly — that looking at the yield curve is a much better way of predicting the future than listening to economists. (Which isn’t saying much.) Right now, the yield curve is steepening quite dramatically, which Baum reckons constitutes a sign that “a proliferation of green shoots calmed investor fears of an endless dark winter”.

And what is Baum talking about when she says that between 2006 and 2008 the yield curve was inverted? Well, in cases like that, the yield curve is like a bowl of fruit. It’s great right now, and it’s a lovely day outside, and you’re rather hungry, and you have a bottle of Champagne open, and so if the government wants to take your fruit off you now and give you back a fresh bowl in a week’s time, that fresh bowl is going to have to be substantially bigger than the one you’ve got today.

On the other hand, if the government wants to swap your bowl of fruit today for an identically-sized and just as tasty bowl of fruit all the way out on Christmas Day, then you’d be more interested. You know it’s going to be cold at Christmas, and you know that you’re really going to value that fruit a lot, because fruit won’t be as abundant then as it is now.

So while the yield curve is steep between now and one week, it’s flat between now and Christmas. That’s known as an “inverted yield curve”, and it’s often a sign that things are going to get worse.

On which note I’m going to sign off for the rest of the week. There might be the occasional posting, but nothing regular: I plan to be stomping around fields in Vermont and admiring lines on walls in North Adams. No major bank failures while I’m gone, you hear?

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Comments
14 comments so far

A steep yield curve could also mean that your apples are shrinking and two apples next year are equal in size to one apple today.

Maybe China no longer wants your apples.

Since the steepening of the yield curve is mainly to be seen in the nominal curve rather than the real rates, I demur.

Posted by dsquared | Report as abusive

You must distinguish between real & nominal rates the yield curve can also steepen due to increased inflation expectations. These days this can be checked out using TIPS.

Posted by Tim Bassett | Report as abusive

Thessencrupp reported today plans to stop construction on multi=million dollar carbon steel plant in Mobile, Alabama. Plan to build a stainless steel plant on same site was halted months ago.

America industries are going to their knees and in 8 to 12 months there will be very few small businesses. The only high employment will be having a job with the federal government. What do they sell to the consumers????????

The government will sell hybrid SUV and lousy efficient cars no one will want. Not yet, but they will..

Posted by Griff | Report as abusive

There is also the inverted yield curve where you are willing to give up two apples today for one in the distant future because you will need them then and have no other source and won’t be able to afford any otherwise.

Posted by Lord | Report as abusive

Doesn’t look inverted here:

http://www.bloomberg.com/markets/rates/i ndex.html

Posted by VennData | Report as abusive

Wow, your first 2 paragraphs are actually completely wrong, you’re not talking about the SLOPE of the yield curve, you’re just talking about the LEVEL.

and what is this post about exactly?

I think you were wondering why none of the Pullitzer prizes for journalism were awarded to financial journalists? Could it be that they add confusion not clarity?

Posted by anonymous | Report as abusive

Good point, and good description. With short term rates at 0, it would be hard to have an inverted yield curve these days. And zero is not that bad for the short term since we are experiencing deflation…

Posted by Detroit Dan | Report as abusive

So the yield curve has steepened because short term rates have dropped, and long terms can’t reasonably go to zero with all the uncertainty connected with recent Fed actions…

Posted by Detroit Dan | Report as abusive

Why We Face $53 Trillion in Unfunded Liabilities or $455,000 per U.S. household

http://seekingalpha.com/article/111998-a ddison-wiggin-s-i-o-u-s-a-the-coming-ent itlement-meltdown

Addison Wiggin’s I.O.U.S.A.: The Coming Entitlement Meltdown 6 comments
Why We Face $53 Trillion in Unfunded Liabilities or $455,000 per U.S. household

According to the Treasury Department’s 2007 Financial Report, we currently face $7 trillion in unfunded liabilities for Social Security, $34 trillion in unfunded liabilities for Medicare and $12 trillion in unfunded liabilities for public debt and civilian and military benefits.

That’s $53 trillion… or $455,000 per U.S. household.

Posted by hungry | Report as abusive

The Holy Grail to Investing.

Developed multiple arbitrages for the financial markets. Arbitrages that produce just a few percent a year, to arbitrages that produce over 30 percent a year.

In 2001 i started developing, as of now, a dozen arbitrages. I lock in an X percentage, and Y time later, i close out the arbitrage. Over 30%/yr.

Risk-Free Investing is not only possible, but in abundance. Just that people are told and taught that it is impossible. No risk has been in front of all, but not seen.

The market is unlimited.

For sale.

Thomas Adair
thomasadair@hotmail.com

Posted by thomas adair | Report as abusive

Some of the elements of Capitalism, like it or not, are loans and equity behind those loans. Banks, or financial institutions, are, and have been for a long time about profit.

It so happens that most banks hold most of our money. In my view, Capitalism needs to be fair. Unregulated institutions that take huge risks are for people that can afford the risk, not for the working class who in many ways, support the ruling class.

Joe Blow has the right to the retirement he earned.

It’s one thing risking your own cash in the markets, but quite another risking other people’s money.

Most banks control funds that belong to the general public. They don’t have any business taking huge risks and Main Street has a right to their retirement which they earned.

Capitalism isn’t inherently evil, it is the greed that comes with it that needs to be regulated. If unchecked, stratification will become a giant problem. The ruling class cannot continue to step on the working class.

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