Tuesday, May 12, 2009

Why You Gotta Luv the Yield Curve

Caroline Baum over at Bloomberg, who is probably their best columnist, writes:
I probably write about the yield curve more than any single subject. I both understand and believe in it.

Too Simple to Understand

The yield curve, or spread, has several things going for it:

First, it’s a leading economic indicator, officially added to the index designed to predict the economy’s ebbs and flows in 1996. It was a leader well before that, even though it was unofficial.

Second, what you see is what you get. The spread is never revised, always available and in no way proprietary.

Third, and most curious, the majority of economists don’t get it. They see rising bond yields in isolation -- without paying attention to what that price-setter, the Fed, is doing at the front end of the curve.

It’s the juxtaposition of short and long rates, not their level, that conveys information about monetary policy.
This final point, btw, is one I pointed out in a post earlier today that Joe Weisenthal doesn't get.

As for the nature of how the yield curve is a leading indicator, when long term rates are higher than short term, banks are aggressively making loans, thus filling the system with money. When short term rates are higher than longer term, the opposite happens, banks are then making less loans, thus draining money from the system.

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