Yield Curve Inversion

Every once in a while, I turn to some topic that stimulates my curiosity.

One such recent topic has been the phenomenon of yield curve inversion. Yield curves describe interest rates as a function of the maturity of the underlying treasuries. One would expect that longer maturity should demand a larger rate as short term rates increase. However, recent observations show an inversion of this dynamic tendency in the yield curve.

The Federal Reserve bank presidents and chair have been opining on the reason for the inversion. Fed Chairman Ben Bernanke has attributed the yield curve inversion to excess global savings compared to investment. Savings are often kept in longer term (longer maturity) securities. In other words, such savings increase demand for longer-term securities, increasing their prices and depressing their yields. (The yield of a treasury is determined based on its price and semi-annual coupons. Price varies based on demand, but semi-annual coupons are pre-determined. If price goes up, the coupons payments will represent a lower rate of return or yield.)

On the other hand, other eminent members of the Fed, for example Timothy Geithner, Federal Reserve Bank of New York President, seem to be of a different opinion. Writes Greg IP of The Wall Street Journal ("Fed Official Warns Of Rising Danger Of Budget Deficit," WSJ, March 10, 2006):

Mr. Geithner tackled the various explanations cited for why U.S. long-term interest rates are unusually low and singled out foreign capital inflows as the most important. Many countries such as China hold their currencies steady against the dollar by investing dollars accumulated by large trade surpluses back into Treasury bonds and other dollar-denominated securities, holding down long-term interest rates. They have also held their own interest rates low to discourage speculative inflows of capital that would buoy their currencies.

In addressing the Japan Society in New York, Mr. Geithner said this phenomenon carries several risks. It may "mask" the impact on interest rates of large budget deficits, "perhaps contributing to a false sense of reassurance" that such deficits won't "crowd out" private investment and hurt growth. Private investors might mistakenly believe positive fundamentals are holding down rates, he said, leading them to "raise leverage...and to take on more exposure to risk."


The Wall Street Journal, March 10, 2006, Page A6.

On the same day, only a few pages earlier, Jackie Clames writes how "Pentagon's Blank Check May Be Withdrawn" (WSJ, March 10, 2006). Clames notes while "expenses for operations in Iraq and Afghanistan will remain favored" in the House and the Senate, both houses are beginning to feel uneasy with the size of the defense budget, as reflected in the blueprints for fiscal 2007, and would like to make "difficult choices" in an environment where "there is no such thing as an unlimited budget" —

This year's $560 billion, which includes Mr. Bush's latest emergency war-spending request for $67.6 billion, is up nearly 70% from the $334.8 billion for defense when he took office. Last month he requested $513 billion for 2007. But that doesn't fully reflect the likely war costs that Mr. Bush for three years has sought through "emergency" supplemental appropriations.

The sums are rattling lawmakers. So is the administration's practice of keeping separate books for the regular defense budget and for war expenses, which increasingly are including new planes and helicopters to replace ones lost in the Mideast. That troubles some members of Congress -- [Senate Budget Committee Chairman] Mr. [Judd] Gregg this week called them "shadow budgets" -- because supplemental war requests get less scrutiny, given the relative speed with which emergency appropriations are passed and the deference that lawmakers accord the commander in chief.

While there are complaints, the moral questions have been predetermined, and the complaints are about the efficiency of expenditure, not the goals.

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