Montreal, August 15, 2005 • No 157




Chris Leithner grew up in Canada. He is director of Leithner & Co. Pty. Ltd., a private investment company based in Brisbane, Australia.




by Chris Leithner

          A yield curve is a chart. It plots the yields (that is, the interest, expressed in percentage terms) paid by certain securities, usually government bonds, on its vertical axis and their term-to-maturity on its horizontal axis. It thereby depicts the returns of securities whose risk is comparable but whose maturities differ. Under fiat money arrangements, the yield curve normally slopes upwards – that is, the longer the duration of otherwise comparable bonds, the higher their yields.

          In the U.S. during the past nine months, the slope of the Treasury yield curve has flattened considerably and during the past several weeks become flatter than at any time since early 2001. The spread in Canada, where the yield of 10-year government paper is lower than at any time since that country's last sane Prime Minister, Louis St. Laurent, held office (1948-57), is even lower (i.e., its yield curve even flatter). And in Australia, the yield curve has been inverted – in other words, 90-day yields have been greater than 10-year yields – since September 2004 (see also "What's With the Yield Curve?" by Frank Shostak).


          Why are yield curves in these countries flattening and even inverting? Why should investors care or even notice? Because since the Second World War in most Western countries, the yield curve has tended to invert roughly 6-18 months before the onset of recession (for a recent summary of this literature, see Paul Cwik, An Investigation of Inverted Yield Curves and Economic Downturns, Ph.D. Thesis, Auburn University, May 2004). An inversion today does not necessarily mean recession tomorrow; but a recession is almost always preceded by an inversion. Japan since the mid-1980s is the major exception – perhaps because during most of this period that country has been mired in recession.

          More specifically, an inverted yield curve is usually but not invariably an early manifestation of two variants of recession (i.e., a credit crunch and a resource crunch). Before and perhaps during the "crunch" phase of the business cycle, the central bank begins to fear incipient price inflation. It therefore tends to decelerate its rate of monetary expansion. This, it is important to note, has occurred in Australia and the U.S. since roughly mid-2004. Also at this point in the business cycle, the prices of inputs tend to rise more quickly than prices of outputs (ditto in Oz since last year). Each of these scenarios encourages the inversion of the yield curve.

Deriving and Explaining Yield Curves

          Central banks, it is vital to appreciate, do not set interest rates; instead, they can only dictate a single rate (in Australia, the overnight cash rate at which commercial banks lend excess reserves to one another in order to conform to requirements set by the central bank). The OCR influences rates further to the right along the yield curve – but so too do other factors beyond the central bank's direct control. Its normal policy (i.e., the damaging inflation which it obscures under the pleasant euphemism "monetary stimulus") thus depresses short-term rates below the level that would prevail in an unfettered market. By decreasing short-term rates relative to longer-term rates, this policy causes the yield curve's slope to become (more) positive. The steepening curve, in turn, generates very strong incentives to undertake "carry trades" – i.e., to borrow short-term money (and pay relatively low rates of interest) and to invest it in longer-term projects and securities that produce high (relative to short-term rates of interest) yields.

          A positive and steepening yield curve is to investors what crack cocaine is to junkies: it has superficial attractions and a positive initial impact, but is also dangerously addictive and thereby risks long-term destruction. Human beings have an innate capacity to overdo things; accordingly, too much of something (such as artificially cheap credit) that seems superficially to be a good thing is never enough. And hence the bitter fruit of the central bank's monetary stimulus: it eventually induces many otherwise intelligent people to undertake "malinvestments." An investment project such as a factory or an apartment building that would not be undertaken if the rate of interest were (say) an honest 8% may become feasible at an artificial rate of 5%. The trouble, of course, is that the project's false viability quickly becomes evident if rates revert to 8%. The positively sloped yield curve and the attractions of various borrow-short-and-invest-long "carry trades" entice entrepreneurs such that – even if they know better – they undertake and do not quickly terminate such "investments."

          Given artificially low rates of interest, poor investments accumulate throughout the structure of production. In other words, both short-term and long-term malinvestments emerge. The short-term ones are direct consequence of the artificial decrease of short-term rates. The long-term ones, on the other hand, are an indirect consequence of the carry trade. People who borrow "short" in order to invest "long" tend to increase the demand for long-term assets (including bonds). This demand increases their prices – and thereby places downward pressure upon their yields. In so doing, central banks and participants in carry trades connive to make long-term credit available at rates below those that would prevail without these interventionist shenanigans. And to depress long-term rates below free market levels is to invite long-term malinvestments.

          During the "boom" phase of the business cycle, which is fuelled by monetary stimulus and reflected in a steepening and upwardly sloping yield curve, poor investments are made throughout the structure of production but tend to cluster in its early (i.e., raw materials and capital goods) stages. As their name implies, these malinvestments are uneconomic; as such, they must eventually be purged. Before or at the boom's apex, expectations begin in three senses to fall short of reality. First, the monetary authority's fear of price inflation (an eventual consequence of its inflation of the money supply) induces it to reduce the rate of monetary growth. To do this, it typically must threaten to raise or actually raise the short-term rate it controls. Second, people and projects whom commercial banks belatedly realise are not creditworthy are less and less able to obtain the funds necessary to complete their investment projects. Third, creditworthy people can obtain additional finance only on terms that render their projects unviable (the second and third points are partly but not wholly a consequence of the first). Notice that under these infrequent conditions, interest rates are able (if only imperfectly) to perform the job that the laws of economics give to them and governments strive to deny them.

"A positive and steepening yield curve is to investors what crack cocaine is to junkies: it has superficial attractions and a positive initial impact, but is also dangerously addictive and thereby risks long-term destruction."

          During the boom, entrepreneurs scramble to obtain the finance required to complete their projects, repay project-related debt and proceed to the next debt-financed project. And towards its apex their demand for short-term finance (they typically cannot meet the more stringent terms of longer-term credit) places upward pressure upon short-term rates. This rise of rates renders their projects even less viable and hence their malinvestments more visible. Their liquidation (i.e., the recession or downward leg of the business cycle) thus begins. When short-term rates rise relative to long-term rates, the yield curve flattens; and if entrepreneurs' desire for the short-term finance that is required to complete their projects is sufficiently voracious – and if central and commercial bankers belatedly find sufficient religion (this, of course, seldom occurs) – short-term rates rise above long-term rates and the yield curve inverts.

          This development, from the point of view of participants in various carry trades, is extremely painful. Traders now possess short term debt on which a rising rate of interest is payable; and if the coupons and unrealised capital gains from their longer-term investments cannot cover these short-term debts, they will find themselves in an increasingly bitter pickle. Paul Cwik notes that the business cycle's crunch phase may take the form of

1. a credit crunch: when significant numbers of entrepreneurs (i.e., those who cannot finance themselves with long-term and investment-grade bonds) are no longer able to obtain at an affordable price the finance they require to complete what they begin to realise are malinvestments;
2. a resource crunch: when the monetary authority's policy of inflation increases the prices of many inputs relative to the prices of many outputs, such that entrepreneurs cannot obtain at affordable prices the goods, services and labour they require to complete what they come to realise are malinvestments;
3. or some combination of the two.

          Those firms that fall prey to credit or resource crunches enter administration and perhaps liquidation. But these things do not happen overnight. The yield curve thus tends to invert before – in practice, roughly 6-18 months before – the business cycle's turning point. Its crunch or recession phase commences the salutary process whereby unviable (in the sense that they do not conform to consumers' wishes) investment projects are liquidated. Given contemporary monetary arrangements, genuine bust is an eventual and inevitable consequence of artificial boom. The monetary manifestation of incipient bust (i.e., an inverted yield curve) is thus a logical consequence of the monetary manifestation of artificial boom (a positively sloped curve).

Scenarios versus Predictions

          Just as there is a structure of production, there is also a structure of speculation. Its most visible manifestation is the yield curve. Like virtually everything else these days, governments corrupt it; yet despite its distortion, the curve occasionally emits genuine warning signs. But these signs are not infallible. The larger body of Austrian School economics also includes many insights about uncertainty, subjective valuations and individuals' many and varied perceptions. On any given day and from week to week, much occurs in financial markets that has much to do with individuals' attitudes and little to do with central banks' policies. Accordingly, Austrians and investors must resist the temptation to interpret the yield curve (and apply the broader theory of the business cycle) deterministically.

          Only a dummy, then, would automatically conclude from the foregoing that Australia, for example, has entered or will shortly succumb to recession. Forecasters, it bears repeating, are seldom in doubt but usually in error. Yet modern yield curves do not often invert, and still less often do they invert for eight months without breaking something. On that basis, only somebody who is blind to logic and evidence believes that during the next couple of years Anglo-American countries will be immune to recession. The fundamental point, then, is not whether one or another country is on the verge of a downward leg of the business cycle: much more important are the principles, methods and plans that enable the investor – whatever the current and future conditions – to navigate variable investment waters.

Two Real Conundrums

          Earlier this year, Fed Chairman Alan Greenspan noted the occurrence of two things (namely the recent tendency of long-term interest rates in the U.S. to fall at the same time that the Fed has been raising the target level of the federal funds rate) that from his point of view are unusual. "For the moment, the broadly unanticipated behaviour of world bond markets remains a conundrum." From my point of view, this behaviour is not a mystery – quite the contrary, it is broadly consistent with Austrian Business Cycle Theory (ABCT). If one admits the possibility of recession, then no riddle exists.

          What is a puzzle is that although central planning in its broadest sense has been utterly discredited, most people – and particularly powerful and influential people within governments, universities and major financial institutions – fervently support central planning as practiced by central banks. But their support exacts a heavy toll. The trouble with the "welfare state of credit," as James Grant dubbed it in his excellent book The Trouble With Prosperity, is that it unleashes speculative frenzies. It ignites excessive risk-taking whilst simultaneously attempting to prevent the losses that inevitably follow the speculation. The central bank launches the false boom that causes the genuine bust; and it attempts – successfully for a time, perhaps a long time, but never forever – to abolish the bust. Like other forms of the welfare-warfare state, it featherbeds the anointed ιlite and leaves the benighted mass to fend for itself.

          One puzzle, in other words, is not that the welfare state of credit regularly bequeaths to borrowers and lenders interest rates that do not tell the truth about time. No individual, however intelligent and dedicated, knows what a "correct" rate is or should be or will be. The puzzle is that virtually all investors happily assume (if they ever bother to think about it) that a very small number of their countrymen, namely central bankers, do know. Participants in financial markets, it seems, need to believe that somebody is in charge. The idea that the man at the controls is neither omniscient nor omnipotent would probably startle the speculator who borrows heavily to buy an "investment" property or opens a margin loan to buy a portfolio of stocks. And the entire point of a welfare state, whether of credit or of labour, is to infantilise rather than frighten. Instead of this torpor, investors would be far better served by epiphanies like the one Dorothy experienced when Toto opened the long curtains and she spotted the "Wizard" frantically – and absurdly – trying to maintain appearances.

          A second conundrum is that if anyone within America's vast bureaucracy could write an intelligent essay about free-market monetary ideas, it would be Alan Greenspan. Not only does he understand them: during the 1960s he professed them passionately (see in particular his chapter entitled "Gold and Economic Freedom" in Ayn Rand, ed., Capitalism: The Unknown Ideal, Signet, 1966, repr. 1986). It is true that since 1987 he has often warned about cycles and excesses. But never profoundly: as a central banker, Mr Greenspan has never acknowledged the crucial insight, of which he is well aware, that artificial booms cause genuine busts. Instead, he has repeatedly regarded the ups-and-downs of the business cycle as things that – trust him – he can put right. Why do Mssrs Greenspan, Dodge and Macfarlane, and their counterparts in other countries, present themselves as stabilising hands at the controls? Precisely because they roil rather than calm the economic waters, they are very powerful; further, soothing words and an aura of stability maintain their power and lengthen their tenure. Viewed in this light, the desire for long-term authority poses absolutely no conundrums.