WorkShy wrote:TheMotorcycleBoy wrote:Thanks - very interesting. So regards the inverted spread, say in interest rates, over 1,2,3 years, is this due to central bank nervousness upon any budding entrepreneurs wanting to start-up a new business in the immediate short-term?
That is, a new short term loan is pricier than an existing one to try to discourage new business, but not penalise existing ones too much?
Sorry if it sounds as if I'm clutching at straws here, I'm just trying to map your remark re. "monetary policy" to these movements in (see below) a somewhat abstracted curve:
Matt
I'm have to be honest I'm not quite sure what your are asking (I may be being dense).
No worries. I'm pretty new to this, so am still fishing around trying to learn the basics. Mostly from an academic viewpoint.
WorkShy wrote:At the start of a typical tightening cycle, the front-end of the yield curve, say 2-year, is at a low level since the prior move was probably a cutting cycle that brought policy rates down. The 10-year point of the yield curve, however, will not be so low since long-dated yields will be driven by longer-term views on inflation and real yields. As a result, the yield curve will be relatively steep.
1. As the central bank raises rates, it takes away accomodative monetary policy. The front-end of the curve rises. Longer-dated yields, however, rise less since they are being driven by much longer-term views of real yields and inflation which have not altered. The curve bear flattens.
2. At some point, the market may perceive that the central bank may be tightening too much. It will price out further tightening, so the the front-end (2-year) stops moving higher. Concern that the economy may slowdown and inflation fall may cause longer dated yields to fall. The curve bull flattens.
3. If the market is correct, and a slowdown/recession happens and inflation falls, then at some point the central bank will respond by cutting interest rates. The front-end now falls rapidly, while the long-end, which has already priced this concern, falls far less. The curve bull steepens.
4. Finally, the market may percieve that the central bank has cut too much and will stop. The front-end stays unchanged, but the long-end yields start to rise on the back of higher inflation and growth expectations. The curve bear steepens.
And we are back to to where we started with front-end rates low and a steep curve... and the policy cycle starts again.
Over most of 2016-18 we were in phase 1. In November/December, the curve started to act like phase 2. It's not clear whether this is just a short term swoon and we revert back to phase 1 or we stay in phase 2.
Also note I'm horribly oversimplifying. Looking at the yield curve (say 2y, 5y or 10y) in "par space" or "spot space" is less useful than looking at the yield curve in "forward space" but this would require some understanding of how derivatives like interest rate swaps can be decomposed into forward starting strips of Libor expectations.
This is very interesting - thank you.
I think that what I was confusing in my earlier post was the raising of rates occurring due to the central bank attempting to use this as an inflation curb, with using a rate rise to deter enterpreneurs from forming startup companies in what the administration believe could be calamitous times. (Which is why I wrote the possibly misplaced this phrase a new short term loan is pricier than an existing one in that earlier post).
I had confused these short maturity yields (what you explain are actually better modelled by "swaps" or derivatives or some such), with the rate for a short term personal loan (e.g. agreed with one's bank), whereas I now realise (correct me if am wrong!) that actually the central bank rate is merely the fixing of the minimum single rate that people can lend at that very point in time - rather than a set of different rates for different loan durations.
many thanks,
Matt
....I was just worried that the debate could turn a little circular, and at the time didn't want to entertain that.