Interest Rates & Yield Curves
By Colin Twiggs
November 1, 2007 4:00 a.m. ET (7:00 p.m. AET)
In an attempt to make the newsletters more readable, we will
trial splitting the weekly coverage in two: gold, oil and forex
on Tuesdays; the economy and interest rates on Thursdays.
Please give us your feedback when we conduct a survey, in a few
As expected, the Fed lowered the discount rate to 5.0% and the
target for the federal funds rate to 4.50%, a quarter per cent
cut in both rates.
Discount rates on commercial paper declined in anticipation, but the spread between (pink) financial CP and (blue) asset-backed CP indicates the market's continued wariness of the almost $900 billion of asset-backed commercial paper in circulation. The level is expected to decline over the next few months, forcing banks to substitute on-balance sheet funding.
The spread between the (yellow) 3-month treasury bill yield and the (pink) discount rate on financial commercial paper reflects the level of unease with financial markets in general. Only when the margin has narrowed to half a percent (50 points), as reflected prior to August, will this signal that the subprime crisis is over.
GDP growth came in at a healthy (annualized) 3.9 percent for
the quarter. When we look at the percentage change on an annual
basis (2007 Q3 compared to 2006 Q3) we can see why the Fed
chose to proceed with the rate cut. Private residential
investment has fallen sharply, even when compared to the
previous two recessions.
The difference between 2007 and 1991 is the resillience of durables and non-residential investment (though defense spending has also played a part). We need to keep a weather eye on these two sectors for signs of slow-down, which would warn that the economy is sliding into a recession.
Source: Bureau of Economic Analysis
The 2001 recession can be ignored for purpose of comparison. It is not atypical and can largely be ascribed to the aftermath of Y2K, with a decline in equipment & software investment and a similar fall in exports.
Ten year treasury yields are recovering as a result of the rate
cut and consequent weakening of the dollar.
The yield differential remains positive as a result of the sharp decline in short-term yields, reducing the pressure on bank interest margins.
Jonathan Wright's recession prediction model indicates the probability of a recession in the next four quaters has fallen to a low 19 percent. The model is based on the nominal level of the fed funds rate and the yield differential between 10-year and 3-month treasuries. As such it fairly accurately predicts a decline in the availability of credit caused by a narrowing of bank interest margins. However, it will not reflect a decline in availability of credit caused by other factors, such as a collapse of the commercial paper market. Not all recessions are atypical, as I pointed out earlier. While the model remains a useful tool, I believe that it underestimates the risk of recession in the present environment.
The spread between high-risk and low-risk corporate bond yields is another useful warning sign. Note how the spread between AAA and Baa bonds spiked sharply upwards in 1990, 1998 and 2001 — reflecting concern about the impact of a down-turn on lower-ranked corporates.
The current low 85 point spread is positive sign, reflecting no immediate concerns about debt servicability.
Let me issue and control a nation's money and I care not who
writes the laws.
~ Mayer Amschel Rothschild
To understand my approach, please read Technical Analysis & Predictions in About The Trading Diary.