The Inverted Yield Curve Signal a Coming Recession?
Understanding Yield Curves and Business Cycles in Economics
Regular Yield Curve
A regular yield curve is a graphical representation of the relationship between interest rates and the time to maturity of bonds. In Austrian economics, interest rates are determined by the interplay between time preference and supply and demand factors. While the theory can be complex, it generally simplifies the different interest rates into a single yield curve for analysis purposes.
In the financial world, loans and borrowings come with varying maturities, ranging from overnight to 30 years for a mortgage or shorter periods such as 20, 10, or 5 years for a car. Each of these maturities comes with different interest rates, creating what we call the term structure of interest rates.
The yield curve, which represents the term structure of interest rates, shows the relationship between the interest rates and the time to maturity. The yield curve typically slopes upward, indicating that the longer the maturity, the higher the interest rate. For U.S. treasuries, which have minimal default risk, the yield curve has the short end, i.e., one and three months, at a lower interest rate than the 10, 20, and 30-year maturities.
Inverted Yield Curve
An inverted yield curve occurs when the long-term rates are lower than the short-term rates. This phenomenon has been historically linked to a recession, as on average, a recession occurs four to six quarters after the inversion of the yield curve. It's an ominous warning signal for the economy.
Current Yield Curve
The current effective fed funds rate, which is the rate manipulated by the Federal Reserve, is 5.08%. Additionally, the three-month rate is 5.3%, the five-year rate is 3.49%, the 10-year rate is 3.5%, the 20-year rate is 3.9%, and the 30-year rate is 3.8%. This creates a significant disparity, with higher rates on the short end and lower rates on the long end. This level of inversion has not been seen since the summer of 1981.
Austrian business cycle theory
Austrian business cycle theory highlights the impact of artificial credit expansion on the economy. This expansion leads to lower interest rates and increased investment, which often results in overinvestment and malinvestment. During this phase, the economy experiences an artificial boom, with people investing in areas that may not be suitable for long-term growth. For instance, a person with enough bricks to build four houses may start six foundations, but may not have enough bricks to complete them. As more people invest in these areas, resources become scarce, leading to an increase in prices and pressure on interest rates.
If the FED intervenes by limiting credit to decrease inflation, it leads to a credit crunch, or else, a real resource crunch where resources become scarce, leading to an increase in short-term rates. This is the upper turning point of the business cycle, where both a resource crunch and a credit crunch occur. When this happens, there is a mad scramble for resources, with people eager to acquire them at any cost. This scramble, in turn, pushes up short-term rates, as people try to acquire resources to complete their investments.
The Federal Reserve's Monetary Regime
The Federal Reserve has implemented a new monetary regime where they manipulate the yield curve by performing Target asset purchases and quantitative easing to avoid an inverted yield curve and prevent a recession. The Fed has lowered the reserve ratio to zero and flooded the system with vast amounts of money. Banks are given interest on their deposits at the Fed, and this has placed a floor under them, making them inactive in the FED funds market.
Non-bank institutions such as money market mutual funds and government-sponsored enterprises can participate in the FED funds market, and the Fed controls the quantity of money in the market through non-borrowed reserves. The overnight repurchase agreement is the floor of the FED funds rate, which currently sits at 5.05 percent. The interest on reserve balances is at 5.15 percent, and the effective fed funds rate is at 5.08 percent.
The Fed believes they have solved the interest rate and yield curve problems, but there are secondary consequences to this infusion of cash that need to be considered.
Multiple Economic Bubbles
During the 2007-2009 recession, the crisis was primarily concentrated in the housing market and mortgage-backed securities. However, in the current economic situation, the crisis is more widespread and diffused. Some of the money is still flowing into the housing market, but many banks are not lending it out and instead investing it in areas such as cryptocurrency. Silicon Valley Bank is one such example.
This time around, there are not just one or two bubbles, but multiple ones, making the situation larger and more complex than the 2007 crisis. As the bubble grows, so does the potential for misallocation and malinvestment. It's evident in our surroundings, such as the understaffing in restaurants and stores, and supply chain disruptions. This misallocation is a result of production structures being out of whack, and it's difficult to determine the extent until after the fact.
Wrong Recovery Policies
Once the downturn occurs, we rely on politicians to implement policies that can aid in recovery. Unfortunately, history has shown that bailing out failing businesses and avoiding bankruptcies, as seen in Japan in the 1990s and during Obama's presidency in 2008, leads to an anemic recovery with slow growth.
Politicians' policies will determine the severity and length of the economic downturn. If they continue to prop up failing businesses without allowing for natural market corrections, they will exacerbate the situation.
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