Photo Source: Max Pixel
Most people are, to some degree. Hotels don’t have a 13th floor. Friday the 13th is considered an unlucky date, and seven is a lucky number. Magic often plays a big role in popular culture. Witches and spells play a major role in the TV series The “Game of Thrones,” and “Harry Potter” books and shows are built around magic.
Science fiction writer Arthur C. Clark once asserted that any sufficiently advanced technology is indistinguishable from magic. That’s how people often approach things they don’t understand. It’s complicated, there’s a mysterious set of inputs and outputs, so it must be magic. This helps explain how folks can confuse correlation and causation. Things happen together, so there must be cause. I wave my hands and the traffic light turns green. So the next time I drive up to a red light, I wave my hands to see if I can turn the light green again.
That’s the way many folks approach the market. If one thing precedes another, it must cause that thing. They yield curve is a great example. Last month folks began to panic because the difference in yields between different US Treasury Notes disappeared. And we know that when something disappears, magic must be involved.
US Treasury yield curve now and a year ago. Source: Bloomberg
But markets aren’t magic. There’s are reasons that the numbers behave the way they do. The difference in yield for different bond maturities is pretty basic: more things happen in a long period of time than in a short period. Longer term bonds usually pay investors a higher interest rate to compensate them for the additional risk. When short-term bonds pay more, something is out of joint. By comparing yields from two different time periods, we can try to understand changes in how investors feel about risk.
But it’s complicated. Lots of things are going on in the yield curve. The Federal Reserve sets short-term rates, and they leave long-term bonds alone, or at least they used to. But they purchased trillions of dollars of bonds after the financial crisis, to keep the economy moving. Now their balance sheet management creates a lot of abnormal distortions.
Recessions come when banks can’t or won’t lend. The last recession was so severe because banks across the country lost major chunks of capital due to bad mortgage lending and they had to reduce their lending. An inverted yield curve isn’t magic, it shows the relative price of money. When the curve inverts, new loans aren’t as profitable, because banks borrow short-term money and lend medium-term. In the past, an inverted curve caused deposits to run off. Now, an inverted curve is a price signal, an indicator that money may be more difficult to get.
Bank funding rate vs. 3-year US Treasury Note. Source: Bloomberg
While financial conditions are tight, it’s hard for businesses to borrow money to expand, to innovate, or to fund new ventures. It’s hard because it’s less profitable for the banks. And when business doesn’t grow, the economy slows down or even goes backwards. It’s tight money, not magical thinking, that causes recessions. And right now, funding just isn’t that hard to get.
It’s good to look for leading indicators of economic changes, and the yield curve is an important financial indicator. But it’s only one. Don’t freak out.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”