The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

False Alarm

08/09/2019

If you loan me money and want repayment in one year, there are few things that can go wrong over that year, which would make me unable to pay.  If you loan it to me for thirty years, there are many more things that can go wrong, making me unable to pay, especially inflation over such a long period.  As the time to repayment increases, risk increases.  As risk increases, the interest rate increases.

Except when it doesn’t!

When short term interest rates get higher than longer term interest rates, it is called an “interest rate inversion.”  It has predicted every recession in modern times.  Actually, it has predicted ten of the last five recessions.  The media is full of warnings about the current rate inversion.  The thinking is that –  if the market thinks there will be less inflation in the future, does that indicate less favorable economic conditions in the future or there will be less borrowing in the future or does the market think there is a liquidity problem now?

There are all sorts of time comparisons.  For example,  how do interest rates for six month Treasuries compare with five year Treasuries?  The time comparison most often discussed is the two-year versus the ten-year comparison, called the 2-10 inversion.  Normally, the ten-year rate is 50-100 basis points higher than two-year Treasury rates.  Today, it is only 13 bps.  It is not inverted yet but is getting close.

So what?

There are several economic data points  suggesting recession, but this is not one of them.  One reason is that, as stated earlier, it predicts recessions that don’t happen as frequently as it predicts recessions that do happen.  More importantly, interest rates are no longer as reflective of market conditions as they used to be.  Every since the Global Financial Crisis of 2008/9, the Fed and other central banks control interest rates more than ever.  Before, central banks could control short term rates easily but had little control over long-term interest rates.  Since the invention of “quantitative easing” and “operation twist,” central banks now have more control over long-term rates than ever before.

Bottom Line:  Interest rate inversions are no longer significant, regardless of what the media says.

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