Friday, February 16, 2007

Don't Worry -- It's Only an Inverted Yield Curve

From CBS Marketwatch:

But S&P says, in effect, that we shouldn't be worried.

Their argument, which appears in the Feb. 14 edition of flagship newsletter The Outlook, is that global capital flows have made this country's yield curve less important than it once was. As Alec Young, S&P's international equity strategist, puts it, "Capital flows around the world more freely than ever -- meaning the global yield curve is far more relevant in assessing U.S. economic and profit trends than its domestic counterpart."

What's the current picture painted by global interest rates? To find out, Young turned to a global yield curve in which each country's individual yield curve is weighted according to the share that its gross domestic product has of global GDP. In contrast to the U.S.'s inverted yield curve, this GDP-weighted global yield curve is positive right now, according to Young.

From USA Today:

Every recession since 1960 has been preceded by an inverted yield curve. The indicator's only wrong signal was in 1966, when the curve inverted but no recession followed.

The indicator carries logic behind it. The Federal Reserve pushes up rates to slow the economy, and bond traders push yields down if they smell a slowdown.

"The bond market is telling you they have a pessimistic view of the next 12 months," says Russ Koesterich of Barclays Global Investors.

But Koesterich thinks demand for long-term bonds, especially from China and oil-producing nations, has twisted the curve. As demand rises, yields fall.

Oil exporters held $97.1 billion in Treasuries at the end of November, up from $79.3 billion a year earlier. China's Treasury holdings have swelled to $347 billion, up from $303.9 billion a year before.

In other ways, too, globalization may be diminishing the yield curve's accuracy as a recessionary signal. On one hand, increases in the fed funds rate, the interbank overnight loan rate, can slow the economy. Banks must pay more for deposits. Consumers pay more for loans.

On the other hand, U.S. companies can now often borrow overseas at lower rates. The funds rate, for instance, is 5.25%; the European Central Bank rate is 3.5%. "Our own yield curve is less important when companies can borrow elsewhere," Kalish says.

OK -- I think the S&P argument is pretty weak. A global yield curve sounds like a really nice idea on paper, but I don't think it has much weight outside academia.

The USA Today article makes more sense. They are essentially arguing the following.

Company A is no longer constrained by US geographical boundaries when looking for loanable funds. For companies of a certain size this is true. For example, a company in the S&P 500 does have access to pretty much the whole world's capital pools if it so chooses. However, this argument assumes a low interest rate is the only cost involved in borrowing money. There is also currency risk which has to be hedged against. There may be a ton of other costs involved in borrowing in another country. For example, some countries may have different, more arduous legal requirements for off-shore borrowing. Then there is the cost of investigating and developing the offshore relationships to actually borrow offshore. Short version for borrowing offshore -- there are probably alot of hoops to jump through that go beyond the simple "it's cheaper over there" argument.

The article is also right about the "global savings glut". Basically, the flood of petro-dollars is returning to the US in some form with increased purchases of US Treasury bonds. That makes sense and I think it carries some weight. However, the International Monetary Fund made an observation at the beginning of 2006 that the "global savings glut" is really a decrease in Asian investment. At the beginning of the 21st century, Asian economies were investing at a lower rate. This freed up a large amount of international capital which looked for a new home. If Asian countries return to their previous level of investment, the US economy will be competing with Asian economies for these excess funds.

In addition, US financial institutions' profit margins are less constrained by the US yield curve. For the last 20 years, banks have worked diligently to develop revenue streams that are not dependent on borrowing short and lending long. For example, most banks have built up larger internal businesses that service loans which are more immune to yield curve fluctuations.

However -- and maybe I'm just an old fashioned economists who can't learn new tricks -- the inverted yield curve still bothers me. But I've been wrong before -- I thought Madonna was a 1-hit wonder, after all.