These day (in fact last friday),there was some concern about the pattern of the short term yield curve,which contrary to the expected,was above that one which reflect the long term yield.This means short term returns of Financial instruments (Bonds) were higher in the short run, than in the long run.This is the usual case signalling a recession. -
What is the meaning of Yield curve ?
It means the expected return, for a financial investment taking into account different periods of time and its return profile.Usually in the long run returns are higher than in the short run, because investors who ties up their money for some time to less liquid financial assets,(Bonds), look for a compensation arising from uncertainty and future inflation rates.Thus,the usual yield curve, signal a positive expectations about future economic growth.This is so, because in such a case, Central Banks should apply a restrictive monetary policy to moderate inflation increasing interest rate .So, the future financial returns, includes a risk premium.-
The underlying assumption about this normal pattern are two:
a.- Economic agent are capable of gathering all economic information about economic growth and Central Bank actions in such efficient way, that they can anticipate what is going to be the future economic growth trend and Central Bank policy reaction.
b.- Long run Economic growth trend is boosted by inovation but constrained by inflation, which is the key variable to increase uncertainty .-
However, before getting into the core of the argument ,there are other types of yield curve, aside from the normal one mentioned above.These additional kind of yield curves, signal a different views about the economy. Let review them briefly
1.-Flat yield curve. The expectation is that both, the economy is slowing down and inflation is close to its lower long run trend, as much as lower economic growth rate, mean cooling off inflationary pressures.-
2.- The upward sloping yield curve.Expectations about future interest rate, are to increase it at a faster pace than usual, which could be the case whwn there is a strong rebound, coming out from a deep dowturn(recession).
Finally,it is the one which market worry about .The inverted yield curve , means that short term returns are higher than the long run ones. Following the standard approach,this means economic agent are placing lower return for long run financial investment, because given their ability to understand properly economic information, they believe the economy will get into recession some time into the near future , such that interest rate will have to be lower to get back economic growth.
But is it really that the case?
There are some credible argument to doubt about the strenght of that approach:
a.- Economic agent are not 100% efficient about their expectations. They may fail about it , but it is not their fault: The economy is on its way to normalize the fundamental of the macroeconomic relationship between key variables (inflation, interest rate ,economic growth , and unemployment),following years of quantitative easing monetary policy, which led to the so called "sub normal" stage of the economy with key prices out of the expected .How come that usual model can explain the unusual?
b.- It follows, that the traditional models somehow are measuring inflation with some upward biased, in contrast to the current trend of low inflation or at least weaks inflationary pressures.So markets may expect low inflation to be the "new" normal,for some of the following reasons
b1.-It is the case which better apply for global markets (global scale suppliers).
b2.- There will be less uncertainty given new and more efficient rules for global trade.
b3.- The pace of economic growth will be slower because on the one side, it is the limitations of the fiscal policy expansion(Low fiscal multiplier), but at the same time, there is the expectation of relevant compensatory forces coming out from the supply side deregulation.-
c.- The outcome is that the inverted yield curve, does not necessarily anticipate an economic recession, as long as inflation does not seems to be the constraint for the global economy.It rather fit more properly with a positive trend for economic growth, although at a slower pace than desirable. How come ? If inflation is not longer a restriction, it redcuces uncertainty ,and interest rate may stay at a lower level for longer periods of time.-
