The US yield curve: the “mirror” of the financial conditions

US Yield Curve (29/10/2008), source: Financial Times website

by Juan Pablo Painceira


The importance and hegemony of the US dollar within the global financial system has become the subject of much debate in recent years. As a consequence of the financial crisis the dollar’s position as the world currency has been analysed and challenged by some analysts, for example N. Roubini (http://www.rgemonitor.com/roubini-monitor/). However, another important analytical tool to understand recent movements in the financial markets has been neglected, namely the US Treasuries yield curve. This curve can be seen as a “mirror” of US financial conditions. This is because the state bonds market – and in particular US public securities - has been the key element in the expansion of finance around the global economy in the last 30 years. It has been also the benchmark for other capital assets.

The yield curve has taken on an unusual shape since the beginning of September (around 10th), as there is now a “dent” around the maturity of 2 years. Since then there has been a gradual move towards a “normalization” of the US yield curve, but this anomaly has persisted (http://www.bloomberg.com/markets/rates/index.html). Although the causes are complex –for example the effects of other financial markets such as money market and corporate bonds market – there are some clear short term short term and long term drivers for what has happened.

Short-term, the expectation of rate cuts has driven investor bets towards the short-term part of the curve, implying that there has been a risk premium in the yield curve, mainly around the maturity of 1 and 2 years. It is important to note that the new market for one year T-bills (officially called 52 week bills) was reopened only in June 2008, with the previous auction in February 2001. Another point is that the freezing in the money markets has slashed short-term interest rates, reflecting banks’ preference for hoarding cash and very liquid government bonds.

Longer term, the strong demand for Treasuries around 2 and 3 year maturity can be related to problems in corporate bond markets, where companies have had huge problems in getting finance. The corporate sector has also affected the shortest-term part of the yield curve through the crunch in the commercial paper market (securities up to 90 days market). The Federal Reserve’s balance sheet has showed an increase in what it terms its “other loans” item, where the total amount of securities with maturity over 1 to 5 years is now around $70 billion.

The huge drop in bond issuance in the corporate markets is important for ordinary people as even the biggest companies have had difficulties in accomplishing the simplest of obligations, for example their payroll! It is the main reason why the Federal Reserve has intereved in the corporate bond market through financing operations in the same way it usually does with financial institutions, mainly commercial banks. These operations are called repo operations, where the FED accepts the securities in exchange for cash for a pre-determined period of time. In another words, the Federal Reserve will be acquiring companies’ bonds in order to finance them for a certain period of time.

Finally, the aggressive emphasis on the steepening of the yield curve is related to the recovery of banking industry profitability, where we have the traditional “borrow short and lending long” strategy. However, the Fed has only succeeded in returning the yield curve to its normal shape (upwards) after 2 years maturity, and the fed funds rate has not followed this drop.

This emphasis can be also connected with the banking bailout plans around the global economy, as public financing for the banking recapitalizations is much cheaper. It happens because the US Treasury has been focused on short term financing in its strategy of debt management - the reoffering of 52 week bills and the release of new 3 year treasuries notes are a good example. The main assumption underlining this strategy could be related to the US authorities’ expectations on the final resolution of the financial crisis. As we can see, the US yield curve has much to tell us about conditions in the broader financial markets and economy.

Could Turkey transform the global crisis into an opportunity?

by Elif Karacimen

The recent crisis triggered in the U.S. has attracted much attention from economists regarding the vulnerabilities of developed economies. Nevertheless, the heavy burden the crisis imposes on developing countries seems to have been ignored. Apart from ignoring the fragility of the developing countries to the global crisis, many mainstream economists even suggested that the recent crisis might turn into an opportunity for these economies. This is a widely expressed argument also in Turkey. The Turkish Prime Minister Recep Tayyip Erdogan said in a press conference held at the end of September that “no one should doubt that Turkey will get over current global economic crisis with minimum damage. I believe that Turkey will turn it into an opportunity.”

The argument of transforming crisis into an opportunity for the developing countries stems mainly from the belief that international investors, who have lost money in developed country financial markets, would prefer to invest in emerging market economies, like Turkey, to compensate for their losses.

However the reality for the Turkish economy is that there are many characteristics of its economy that makes it extremely vulnerable to the current crisis. The most important of them is the substantial current account deficit (about 6 % of the GDP), which makes the Turkish economy more vulnerable to the global crisis than many other developing countries. This is because is of ever-increasing difficulty in funding the deficit. Private sector borrowing and short term money flows are the two main channels through which the deficit has been financed. Nevertheless, the current crisis has obstructed both of these channels.

The private sector debt rose by 342 percent, from $43.1 billion to $190.5 billion between 2002 and mid-2008. It is obvious that as the crisis intensifies the private sector will find it very difficult to service its short term debt.

The reversal of the capital flows is another major threat to the funding of the current account deficit and also to the growth of the economy. Within the context of the IMF-led economic programs, maintenance of capital inflows became an inevitable condition of the economic growth. The economy achieved high growth rates after the 2000-2001 financial crises (6% on average between 2002 and 2007) due to the large international capital inflow. High interest rates attracted the capital flows and in turn the abundance of foreign currency led to appreciation of the Turkish lira. An overvalued exchange rate stimulated the imports of consumption and investment goods. But as world liquidity diminished foreign investors began to withdraw their money out of the country, and so maintenance of this import driven growth and also funding the large current account deficit have become impossible.

As a result, given the vulnerable characteristics of the Turkish economy, it is not reasonable to expect that Turkey can transform the crisis moment into an opportunity by attracting international capital inflows.

A 1989 moment?

by Costas Lapavitsas

The current crisis is a regime break for the global economy, irrespective of its eventual resolution. For more than two decades the premise of economic policy-making has been ‘private good - public bad’, always favouring market solutions to state-based interventions. This has now been damaged beyond repair. Policy-making can be expected to put fresh stress on the public though the form this will take is not yet clear.

Keeping the proportions, the crisis has analogies with the collapse of the Eastern Bloc in 1989-1991. After the fall of the Soviet Union the credibility of socialist ideas and policies received a body blow. The best that the Left could do was call for ‘anti-capitalist’ policies or ‘resistance’ to the neo-liberal onslaught. This is likely to change, though a lot will depend on whether the Left can put forth innovative ideas and proposals.

There are several reasons why this crisis might lead to such profound change, four of which immediately come to mind. The first is its sheer magnitude. Global losses for banks already stand around $650bn. In the USA alone 17 major financial institutions have failed so far. By the time the crisis is over the cost for the USA is likely to run to several percentage points of GDP, perhaps in double digits. In other economies, for instance, the UK, Ireland and Iceland, things could be even worse. And that is without counting the social cost of the coming global recession.

Second, the crisis has been created by private finance at the heart of developed countries. It has nothing to do with bumbling state intervention, or war, drought and other external shocks. And nor is it the outcome of corruption or cronyism, the favourite bogeys of neo-liberals when it comes to financial crises in developing country. The crisis arose because freely competitive, private financial institution in developed capitalist countries proved to be inherently inefficient in organising society’s financial affairs.

Third, the crisis was caused primarily by the advance of finance to private individuals rather than to corporations or small businesses. Since the 1980s, big business has relied less on banks and more on open markets to obtain finance. Banks have turned to lending for mortgages and consumption as well as commissions from mediating financial transactions. Meanwhile, the withdrawal of public provision in housing, pensions, health, education and consumption has driven people into the arms of finance. The costs have been enormous. In the USA alone, close to 20% of disposable income was paid to financial institutions as interest and other charges in 2005, 2006 and 2007. But these costs are likely to be dwarfed by the impact of the crisis on working people.

Fourth, the only factor preventing complete disintegration of the financial system has been global state intervention. Liquidity provision by central banks has been limitless, running into trillions of dollars. Indeterminately large sums of public money have been committed to nationalising (partly or fully) commercial banks, insurance companies and mortgage providers in the USA, the UK and across Europe. Hundreds more billions of dollars are likely to be eventually committed to cleaning up the balance sheets of banks.

The crisis, then, has destroyed the conceit that freely competitive capitalist activity is the most efficient, or even the only, way of organising economic life. Once its sharp phase is over there will be debate on how to rebalance private and public in the economy. The Left should make definite proposals to replace private and individual with public and collective mechanisms in finance and more generally across the economy. A start could be made with housing, pensions, education and health. And, you never know, socialism might be mentioned again.