The Government, Banks and the Importance of the Yield Curve

What's this all about

A Yield Curve is generally a chart showing the relationship between the Interest Rate and the Time to Maturity of a Bond. It is widely used by Fixed Income investors and economists as an economic prediction tool. This week’s Thought provides background to support the theory that the end of Quantitative Easing may not be as bad as many think. Those forecasting the end of economic recovery once the Government shuts off the monetary faucets may be premature. Quantitative Easing has really been about supporting the banking system, not creating jobs and stimulating the general economy.

The Yield Curve

The current yield curve for U.S. Government Treasuries is shown below: the longer the maturity, the more yield (or interest) an investor requires as compensation for the longer holding period and the additional risk this may entail.  As an example of how this helps economists, a steeper curve as you move to the right usually signifies a higher probability of future interest rate rises.

                                     

The Treasury Yield Curve is also an indication of future interest rate policy in that it shows the ‘risk-free’ investment return available by buying a Bond which is backed by the U.S. Government.

  

Anyone buying or selling debt has to compete with this curve. For example, if the U.S. Government will pay you 3.6% a year to loan it money, why would you consider an income investment yielding any less? You wouldn’t, you would ask for a higher return to compensate you for the higher risk. 

The higher the implied risk, the larger the yield “spread” between the competing investment and the U.S. Treasury of the same maturity. Corporate Bonds, which carry the risk of corporate failure and default on interest payments, have similar shaped yield curves but feature higher interest rates. 

One important feature of the current yield curve is the “near-zero” short term level. If you loan money to the U.S. Government for between one and three months, they will pay you virtually zero interest. The interest rate only goes above 1% for loans of three years or more. Normally, short term interest rates are 2% to 3%. 

Banks and the Treasury Yield Curve 

Banks generally borrow at the short end of the yield curve and lend at the long end. Therefore, their profit margin depends on the difference or spread between long term and short term interest rates.  

For example, if a bank issues a 30-year mortgage at 6.6% (the 30-year Treasury plus 2%) and borrows the money from the Government at 1.3% over 3 years, they make a 5.3% margin in return for managing the difference in loan maturities and the difference in risk between lending money to a home owner and borrowing from the U.S. Government.

Note: Pretty much all loans are related to the Yield Curve because all lenders have to compete with the risk-free rate of return offered by the U.S. Government.

Federal Funds Rate (FFR)  

In reality, banks borrow money from other banks at the Federal Funds Rate (FFR) which is controlled, but not set, by the Federal Reserve.  The Fed influences the FFR by controlling the supply and demand for Treasuries.  Bottom Line: The Federal Reserve is lending money to banks, through Quantitative Easing, at near zero short term rates.  

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WILL INTEREST RATES BE RISING SOON?

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Reduced Demand for U.S. Treasuries

At the recent Federal Open Market Committee (FOMC) meeting, a number of members suggested they would be comfortable supporting an increase in interest rates. A few meetings ago, no one was talking about increasing rates, now we are seeing growing Fed support.  Banks are slowly starting to allocate capital to lending activities instead of using it to buy Treasuries.  Reduced buying of Treasuries will reduce demand. 

Moreover, Chairman Ben Bernanke gave a fairly clear indication that QE2 will end and will not be replaced by another round of easing. Quantitative Easing is the mechanism by which the government has kept interest rates low for so long. By buying up many of its own bonds, the government kept demand for Treasuries high which allowed prices to remain high. High prices result in low yields which lead to low interest rates. As demand falls, the Government will have to increase yields to attract more investors. Therefore, if Quantitative Easing ends, expect interest rates to start rising. 

In addition to the prospect of the U.S. Government ending purchases of their own Treasuries, Japan will probably sell some of the U.S. Treasuries it owns in order to fund disaster relief. Putting these securities on the market may reduce demand and prices further. Falling prices will mean rising yields – a.k.a. rising interest rates.

As demand for U.S. Government debt falls, the government will have to raise the yields it offers to attract buyers. This means interest rates will probably rise as bank lending rates are set, in part, by Treasury interest rates.

Federal Reserve Activity

In addition to the change in FOMC opinion discussed above, the Federal Reserve has quietly embarked on two programs which reverse the trend of pumping money INTO our economy:

•  On March 18, it announced that it would start SELLING a $142 billion portfolio of mortgage backed securities acquired in the midst of the financial crisis.
•  On March 23, the Federal Reserve announced it would start reverse-repurchase transactions.  Reverse repos are designed to take cash OUT of the banking system and raise rates.

It appears the powers that control our macro-economic policy are moving from Monetary Easing to Tightening.  This is a good sign for the economy as The Fed must feel growth is strong enough to sustain itself

without the need to pump in liquidity.

Monetary Tightening Begins?

Investors and the press tend to focus on the Federal Funds Rate as the measure of Interest Rate levels; therefore the media didn't take much notice of the Fed’s actions listed above. However, The Fed's moves were the first two definitive monetary tightening actions. We've gone from talking about reducing the money supply to actually taking physical steps – this is important.

Rising Inflation

Anyone think inflation isn’t rising? Although oil price inflation is well documented, increases in a wide variety of producer and commodity prices are now finding their way through to consumer prices.  In February 2011, U.S. consumer prices rose at their fastest pace in more than 1-1/2 years. Food prices soared 3.9 percent in February, the biggest gain since November 1974.

Rising Inflation normally leads to Interest Rate rises.

There are many temporary issues causing commodity prices to rise – Middle East unrest, Japanese supply issues, etc - and these rises could therefore prove temporary, if and when the various causes dissipate.  When companies start to raise the prices they charge the consumer it indicates growing confidence in the demand for their goods. Until now, many finished goods producers have absorbed increased costs of raw materials. It appears this may be coming to an end.  Increased confidence in consumer demand is a positive indicator for the economy and rising prices may help companies beat their revenue targets in their quarterly reports.  

Net Effect of Rising Interest Rates

If the Government allows interest rates and inflation to rise in a controlled manner, it means they feel the economy is back on the sustained growth track, despite all the headwinds and shocks to the system.  Net-Net, this is good news for many companies in the longer term. The Global Financial System still contains numerous imbalances which will take years to either unwind or for growth to catch up.  Most strong stock markets are predicated on a healthy banking system. We are seeing evidence that Banks are starting to heal their financial woes.

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