what is an inverted yield curve and why does it matter?

Seal of the United States Department of the Tr...

Seal of the United States Department of the Treasury (Photo credit: Wikipedia)

In 2002, how did I first learn that investment trends and investment markets were getting ripe to reverse? I studied a forecaster who had an amazing record of success for the prior two decades and I studied his relatively simple logic.
He studied several things including a particular pattern in the trends of lending and borrowing, especially people lending money to the US Treasury, which is also called buying bonds from the US Treasury. Before I detail the specific pattern he studied, here are some simple points of background.
First, who controls lending markets? Who sets the guidelines for how money will be lent?
Lenders control lending markets. Why? Lenders have the money to lend, so they have all the power.
Someone wishing to borrow can come to the lender and apply for loans. The applicant for the loan may or may not qualify, depending on the standards set by the lender. The lender has the money to lend and can choose to lend it or not. The lender sets the qualifications for borrowing and also sets the specific terms of the contract such as the interest rate of how much extra the borrower will need to pay back in order for the lender to agree to lend.
Loan Process

Loan Application Process (Photo credit: IFPRI-IMAGES)

The Treasury !

An ancient Egyptian Temple also known as The Treasury! (Photo credit: Wikipedia)

Next, in US Treasury bond market, who is the borrower? The US Treasury is the only borrower. Someone with money can lend the US Treasury the money on the promise that the US Treasury will pay that money back over time plus a certain amount of extra money as in a particular percentage of interest. Again, the borrower pays interest to the lender. The US Treasury is the borrower paying interest to the one who lends money to them.
So, in the case of the US Treasury bond market, the borrower is so interested in so much borrowing that the borrower invites as many lenders as possible to come to borrower to lend the US Treasury money. The US Treasury sets up a market or a system for lenders to lend money to the borrower.
When the interest rate or yield for long-term debt is lower than for short-term debt, that signals that lenders are offering unusually low rates on long-term debt to attempt to attract new borrowing. In other words, when long-term interest rates are falling, that means that the relative demand for long-term borrowing must be declining and lenders are “chasing” new borrowing by decreasing the “cost to borrow” as in reducing the interest rate.
When long-term yields fall below short-term yields, that is called an inverted yield curve, which could mean that borrower(s) are getting more conservative (increasingly avoiding long-term debt and favoring short-term debt). It could also mean that lenders are getting more aggressive (attempting to attract more long-term debt by offering especially low interest rates).
English: United States Department of the Treas...

English: United States Department of the Treasury Washington, D.C. Deutsch: Finanzministerium der Vereinigten Staaten von Amerika Washington, D.C. (Photo credit: Wikipedia)

Again, lenders control lending markets because they control the qualifications to borrow, but lenders also respond to demand. When the demand by qualifying borrowers favors short-term debt over long-term debt, yield curves invert.
When lots of people are willing and able to lend money, they compete with each other by offering lower rates. When lots of people are especially confident in a particular borrower, then they are eager to lend the borrower money for unusually low interest rates.
Much of the mainstream commentary on “inverted yield curves” is presumptive and elementary at best. One can find many references to expectations of decreasing future interest rates and other issues that may have no basis in the actual conversations of lenders.
Consider the example of a person with a savings account or buying a CD who has the choice of several banks to whom to lend their money (to deposit money in an interest-bearing savings account or CD). Does such a prospective lender talk extensively about expectations of future deflation or falling inflation rates? No, they just look at the rates offered by one or more prospective borrowers (banks) and then choose.
The reconstructed Treasury of Athens, built to...

The reconstructed Treasury of Athens, built to commemorate their victory at the Battle of Marathon (Photo credit: Wikipedia)

Likewise, global investors tend to favor lending to their own country’s treasury, and other than that, they “shop” for attractive bond rates with a rather limited  analysis of forming their own expectations about fluctuations of currency exchange rates and inflation. In other words, global investors simply may not be nearly as analytical and methodical as some people might assume. They may even be highly influenced by the models (myths?) presented by mainstream education and mainstream media.
For instance, why does China lend so much money to the US Treasury? It could be simply because China has a huge trade surplus with the US and lots of excess US Dollars. So, in order to encourage the US to continue to pour so much more money in to buying Chinese goods, the Chinese lend a lot of their US Dollar profits back to the US Treasury so that the US economy can afford to buy more from the Chinese.
Why does the economy slow when people aggressively lend money to the US Treasury? Simply because they are not spending it on something else.
For instance, if the Chinese were buying millions of computers from the US, then the Chinese would not be using that money to lend to the US Treasury. Since the Chinese are using the money to lend to the US Treasury, they are not spending that money on computers or real estate construction or scientific research, but lending it to the US.
Why did the US Treasury have such a surge of long-term lending coming to it? Any answer would be somewhat speculative. However, I offer the following answers for you to consider as to why global investors (lenders) would be so unusually confident in the long-term capacity of the US Treasury over other competing national treasuries worldwide:
1) the US economy had accumulated immense wealth from decades of being the #1 producer of crude oil in the world
2) the US was still the #3 producer of crude oil in the world while Japan and Europe, while also wealthy, were far more dependent on importing fuel than the US
3) the global military empire of the US was (and still is) by far the most influential national empire in terms of political diplomacy AKA intimidation and coercion.
United States Mint Police

United States Mint Police (Photo credit: cliff1066™)

Since I have repeatedly mentioned the issue of Chinese lending to the US, let’s consider the above reasons as it relates to China. The US is the big military superpower and the only real threat in the world to China, right? So, the Chinese have a diplomatic and political interest in keeping the US dependent on their lending. Plus, the US may basically dictate (in the terms of the trade surplus in which the US gives pieces of paper in exchange for things of practical value) that most of that money WILL be coming back to the US, or else the a much less favorable outcome (for the Chinese) would result.
Next, if you were a Chinese investor, would you rather lend money to the treasuries of Greece or Japan, with their rocketing fuel prices and teetering socialist retirement obligations? Wouldn’t you rather lend money to the US, where fuel is so abundant that fuel prices are not $7 or $11 per gallon like in some parts of the world, but only $4? There are many times more working age people in the US per retiree than in Japan, so that leaves a lot more of a potential tax base “untapped.” (Note that government treasuries pay their debts through revenues such as taxation and confiscation of wealth from citizens accused of whatever crimes that a government can make up and then sell to the masses, such as “possession of 1 gram of marijuana.”)
Finally, with a huge trade surplus to China from the US and a huge surplus of US Dollars, what else is a rich Chinese investor going to do with all of that cash? They could invest it in the speculative bubbles of European or US real estate or stock markets, but would that be at all attractive? The influential Chinese tend to be much more conservative (much less naive). They might rather invest in a government treasury, knowing that a powerful and well-armed central government has the capacity to extract wealth from the wealthy middle class of the US through coercion, taxation, extortion, or whatever other labels might be put on the involuntary redistribution of wealth from the general population to the government’s Treasury.
Logo of Internal Revenue Service, USA

Logo of Internal Revenue Service, USA (Photo credit: Wikipedia)

Now, considering that there could be political interests in obscuring these realities, what if the Chinese (or whoever else might be behind these economic interests) were to wish to censor information and misdirect the attention of the masses through the mind control mechanisms of mainstream media and public education? What if confusing the global masses about the simplest patterns in economics were a state priority? Are censorship and government-subsidizing of media and education something that the Chinese are willing to do and capable of doing?
We all know that conspiracy theories are always inaccurate and misleading, such as the idea that a few internationally-recognized Arab terrorists could casually cross a border and then hijack several planes and fly them in to priority military and political targets in the US. Therefore, let’s accuse the Canadians, the Mexicans, the Palestinians, and the Protestants for activities that clearly benefit the economic interests of their official enemies.
By the way, we all agree that it is horrible for an empire to engage in imperialist activities, or for an empire’s army to engage in military actions. Therefore, if the Chinese were to be attempting to influence their own reputation through public relations and propaganda, that would be a violation of the most sacred principles of unrealistic idiocy. Therefore, I assert that the current state of world affairs is due to the sole influence of a secret cabal of Soviet Nazi zombie vampire mummies using a rare and very advanced extraterrestial technology called the human brain (and in particular, the symbolic human languages recognized by the human brain).
English: United States Internal Revenue Servic...

English: United States Internal Revenue Service Criminal Investigation Division Badge (Photo credit: Wikipedia)

English: Secretaria de Administracion Tributar...

English: Secretaria de Administracion Tributaria the internal revenue service of Mexico building located on Reforma Ave in Mexico City (Photo credit: Wikipedia)

http://en.wikipedia.org/wiki/Yield_curve

http://seekingalpha.com/article/23597-the-bond-yield-curve-as-an-economic-crystal-ball

http://www.creditwritedowns.com/2011/09/inverted-yield-curves.html

www.investopedia.com/articles/basics/06/invertedyieldcurve.asp

useconomy.about.com/od/glossary/g/Inverted_yield.htm

knowledge.wharton.upenn.edu/article/1362.cfm

mises.org/etexts/cwik-dissertation.pdf
http://www.forbes.com/feeds/ap/2006/01/06/ap2433228.html
http://www.zerohedge.com/news/japanese-bond-curve-inverts-3y-cash-now-king

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