Why the Yield Curve is Steepening

By: Dr_Jeff_Lewis

Investors know that the yield curve can be used to forecast market movements.  When the difference in yield between short-dated debt and long-dated debt grows or shrinks, the next major move is a bearish or bullish signal for risk-related investments.

Now the yield curve is steepening significantly, but this time, the steepening of the yield curve shows indecision in lending, not indecision in investing.

Negative Rates

This week, the Bank of New York Mellon announced that it would begin assessing fees—effectively negative interest rates—on depositary accounts worth $50 million or more.  As yields on short-term debt plummet, banks which hold retained corporate earnings and deposits from other banks are finding that administering the accounts simply isn’t worth their time.

Yields are so low that the difference between the yield on the account and similar-dated investment vehicles is so small that the Bank of NY would have to provide negative yields on capital in order to make the spread big enough.  This says simply that rates are too low.

The online auction site eBay, which owns the payment solution PayPal, announced that it would be closing its money market fund.  The company previously paid interest on assets held in customer accounts.  Money market funds usually buy assets which mature within 24 hours.  When rates are as low as 2 basis points (.02%) for 3 month Treasuries, the money market fund can generate little more than one half cent for every $100 in investment capital every three months.  The company can’t legally chase returns out that far, anyway.  It’s no wonder why the program was scuttled.

QE distorting capital markets

There’s good reason for record low interest rates: there is so much capital available for short-term, but not long-term lending.  There is also a good reason for the discrepancy in time preference for capital: few investors know how long the capital will be available.

In normal markets, debt structure is managed on the basis that capital is available at all times and at different maturities.  In a market made by a central bank, most capital can be recalled at any moment.  Investors know that the Federal Reserve won’t repo dollars out of the banking system, but is wagering on the possibility worth the paltry yields of less than one-fiftieth of one percent per year?  The simple answer is no.

In the stock market, a series of quantitative easing programs made capital so attractive that investors could raise “call money” through a brokerage to buy investment securities with leverage.  Rates on call money, which earns its name from the fact that the loan can be called at any time, were never much more than 2 percent per year.

Investors leveraged up, of course, pushing leverage amounts on the NYSE to the highest since the last financial crisis.  Now, with quantitative easing ending and the direction of the economy uncertain, a double dip looks likely, and a financial crisis may be just around the corner.

The yield curve is steep because money is too cheap and plentiful in the short-term, but non-existent in the long-term.  The only action that would bring an end to a steepening yield curve is to give investors certainty in capitalization levels, and that means an end to talk for QE3—even if it is a painful pill to swallow.

By Dr. Jeff Lewis

Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of Silver-Coin-Investor.com and Hard-Money-Newsletter-Review.com

Copyright © 2011 Dr. Jeff Lewis- All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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