Yield Curve

Through history there has been many ideas about of how to value the future. I particularly love one of these ideas that the interest paid on borrowed money is the compensation you pay the lender for his pain in forgoing the pleasures that money could have purchased him.

In any case modern financial market have numerous schemes to allow you to price a bushel of corn or money at some point in the future. If you borrow money, for example, you pay interest. Interestingly if you borrow money for a year v.s. ten years you don’t pay the same interest rate. Sometimes you pay more sometimes you pay less. If we plot these various interest rates we get what’s known as the yield curve.

There is a very cool applet showing the yield curve for the last few decades in this magazine article.

The shape of the yield curve is a market signal about what people think the economy is going to do next. Short term rates go up when there is lots of demand for cash, i.e. their are lots options for investing your cash that will bear fruit quickly; i.e. the economy is hot. If at the same time the market collectively senses that economy is going to cool down, i.e. there aren’t good long term investments to be made, then the near term cost of money should be higher than the long term cost. That’s the case right now.

Presumably this means that investors have their attention focused on short range opportunities v.s. long range ones. When they look at longer range investment opportunities the see uncertainty and so they put their time into activities that can be wrapped up in a short, presumably more predictable, time frame.

The yield curve is the market signal that tells us what the investor class is thinking about the future; with the consumer spending and confidence tells us what they are thinking. The market signals says that we live in an uncertain world. Who knew?!?

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