Rising short-term interest rates (represented by 3-month Treasury yields on the chart below) caused negative yield differentials in 2006/2007 which led me to warn of an economic down-turn. Yield differentials are calculated by subtracting short-term (3-month) yields from long-term (10-year) yields. Banks borrow mostly at short-term rates and lend at long-term rates, generating a profitable interest margin. But when the yield differential turns negative, bank interest margins are squeezed, forcing them to contract lending. A lending contraction shrinks consumption + investment and sends the economy into a tail-spin.
Negative yield differentials (or yield curves) are normally caused by rising short-term rates as in 2006/2007, but now we are witnessing the opposite phenomenon. Short-term rates are near zero, but falling long-term rates are starting to squeeze the yield differential from the opposite end. The situation is not yet desperate but a further decline in long-term yields would shrink bank interest margins. Fed initiation of QE3, purchasing additional long-term Treasuries, is likely to drive long-term rates lower and exacerbate the problem. The resulting contraction in bank lending would cause another economic down-turn.
I do not believe this for one minute. The banks can set their interest rates to control the differential. I think this has been an intentional effort to get Obama out of office. The only motive i can figure out is racist.
Grover Lawlis, MD
Great analysis. I bought some “FAZ” (financials short X3 ETF) today and they are already up 3%
QE3 could entail purchasing mortgage backed securities but it matters not since a recession seems to be built into the cake, based on social sentiment. Even if Europe goes the route of bonds it just kicks the can down the road if production (and the expected job creation) doesn’t follow a stimulus. If jobs are the key, as everyone insists, then the door we open with it better be what we expect (which it usually isn’t, according to Black Swan theory).
The last time yield differentials were at a similar level (on the way down) was around April 2005. That suggests at least another two years of glorious insanity before GFC part 2 hits with a vengeance.
We are a lot more fragile now than we were in 2005. On the positive side — long-term rates are likely to fall slower than short-term rates rose in 2005.