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Tuesday, July 11, 2006

Yield Curve Lessons Part II

This is the trio to beat in the next two years! President Bush nominated able and accomplished assistants in Gov. Bernanke to print his money, and Hank Paulson as his cheer leader.

Paulson used to be the head of Goldman Sachs. His nomination confirms the fact that like former secretary Robert Rubin (also a product of Goldman who also became treasury secretary), a good strategy for an investment bank to assure its investors of their returns is to control the economy itself. He is for continuous growth amid debt funding. He admitted to be a team player.

Bernanke, on the other hand, is famously (or notoriously) known as "Helicopter Ben" for his use of Milton Friedman's "helicopter drop" of money into the economy to fight deflation. If Greenspan is a money printing addict, this one's always in the pot session. One of his most famous quote goes : "people know that inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation."

The pot is now in session!


Back to the yield curve.

There are several shapes the yield curve can form. It can be Normal, Steep, Flat, or Inverted. The normal shape points to stable economy in the future, expecting lesser disruptions and uncertainties. The steep shape points to the economy improving quickly in the future. The flat curve has a high percentage of preceeding a weak market in the future although it is not guaranteed. And last, the inverted curve is as we said is abnormal because it is pretty stupid to take on lesser return for taking much more holding period risk.

Now let us dissect the yield curve formula. The simple formula for computing for future rates is by dividing the square root of the present annual rate by next year's expected rate then subtract it by 1. For example, the annual yield on a 1 yr bond is 5% and on the 2 yr bond is 5.5%, then the implicit or forward yield(forward rate) in year 2 is 6% as shown in the formula above.

The inverted yield curve is of major concern because it historically preceeds recessions. So you ask why not the Fed just raise the long-term rates to avoid inversion? The thing is, it cannot. The Fed can only control the short-term rates.

The beef here is that as short-term rates become close to long-term rates, banks would experience margin squeeze. In simple terms, margins of banks are based on the difference between loan rates and deposit rates. They practically lend out the cash that you deposit for higher rates, definitely higher than what the bank gives you. Now, most of the cash that is deposited in the bank has to be invested in safer instruments. Again, in this case, the long-term US treasury bond will be the instrument of choice as it is the safest, returns are almost sure and in trader terms, liquid. Unless you deposit it in the Bank of Wafah Dufour, your money will probably be loaned out again to Osama.

So basically the loan rates that banks charge is based on the long-term rates. Thus, the higher the long-term rates go, the better margins for banks, the more aggressive they will loan out. The lower long-term rates go, the more unprofitable it is for banks which may cause credit crunch that may crimp the economy's growth.

Or should I say recession?

More on the yield curve in our next class.



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