Managing the Yield Curve

There's a nice summary article up at the Christian Science Monitor about the flat yield curve, the chance that it might become inverted, and why it matters to you my dear readers.

Normally interest rates are higher if you borrow or loan money for a longer period of time (credit cards being the extreme exception). A five year CD pays more interest than a one year CD, which pays more interest than a savings account. But sometimes this isn't the case: when interest rates are about the same no matter how long you borrow money, that's called a flat yield curve.

And when interest rates actually go down for longer term loans, that's an inverted yield curve.

Historically, an inverted yield curve often precedes a recession. This is one of the more reliable predictors of an economic slowdown, meaning that it is somewhere between the Superbowl score and reading tea leaves.

Question 1: Does an inverted yield curve predict or cause a recession?

I don't know the answer, but I suspect it is "both." You can make an argument either way.

On the one hand, an inverted yield curve is a signal from the bond markets that they expect future short-term interest rates to be significantly lower than today, and that there isn't much demand for long-term borrowing. These conditions happen when lots of people think that there's uncertainty about the economy, so the inverted yield curve is sort of the collective prediction of millions of borrowers and lenders thinking that the economy will be worse a year from now than it is today.

On the other hand, an inverted yield curve can cause a recession by enticing investors to focus on short-term investments which pay a higher interest rate. This can make it harder to borrow for capital projects, and can be a cause of a recession. Why should a bank write a 20-year mortgage at 5% interest, when they can earn 6% with less risk by buying short-term treasury bonds? In other words, an inverted yield curve sucks all the appetite for risk-taking out of the economy.

Question 2: Can the yield curve be managed?

The yield curve is set by bond markets, but short-term interest rates are already managed by the Federal Reserve, which adjusts its overnight interest rate up or down to try to control inflation and smooth the economy.

There's only one entity which might conceivably have the clout to manage the entire yield curve: the U.S. Treasury. By borrowing at the long end of the market (30 year bonds, for example) and retiring shorter term bonds, the yield curve can be made steeper. Alternatively, by borrowing mainly in shorter durations, the yield curve could be made shallower.

I don't know if even the U.S. Treasury has the financial muscle to actively manage the spread between short and long-term interest rates. But it might be possible.

Question 3: Is managing the yield curve desirable?

If you believe that an inverted yield curve causes rather than merely predicts a recession, then it makes sense to manage the yield curve to smooth out the ups-and-downs of the economy.

The trick would be maintaining a yield curve steep enough so the economy is healthy, but not so steep that investors start taking foolish risks. The argument that an occasional recession is healthy (because it weeds out weaker players) also still stands.

Also, I'm not sure how you would manage things to keep the economy healthy and inflation at bay.

But just asking the question is intriguing.