If you want to spot a turning point sharp downwards in an economy look for that rare occurrence an inverted yield curve.
At many points in the past the inversion of the yield curve has signalled a turning point dowards in the business cycle.
Ok to the non wonkish what is a yield curve and why is it important?
A yield curve is the curve of interest rates on borrowings of various terms. Under normal circumstances the shorter period you borrow for the lower rate you pay. If you believe that interest rates are a return on waiting alone then this would be an explanation – the so called pure time preference theory as held to by most modern Austrian school economists. But the fact that the yield curve can and does reverse blows this out of the water, there has to be something else other than just ‘waiting’ which governs the price of lending. That other thing is the desire for holding assets in liquid form.
There can be several reasons for wanting to increase the liquidity of your assets. Keynes covered a number of them. This can include motivation to realise assets because there are more profitable investments or because investments are going bad or are expected to go bad and transferring to money caps losses at the rate of inflation. Each of these is related to the different functions of money, means of exchange, store of value etc. and what is most important in different economic conditions and degrees of uncertainty. Also when you have a high ratio of liquid assets to illiquid assets you will be less willing to pledge your illiquid assets as collateral for medium to long term loans as this will highly risky in stressed conditions.
As Pesto explains:
in stressed market conditions, if you are a bank in need of cash, it is saner to borrow for a day or a week rather than for a year. Because over the course of a year, there is a danger that the bank that you’ve borrowed from – and is holding your assets as security for the loan – could go bust.
And since the assets you’ve pledge would be worth considerably more than the loan, that risk of the so-called counterparty collapsing isn’t worth taking.
Which means there is much more demand for overnight loans on the repo market than for year-long loans. So the cost of year-long loans is much lower than for overnight loans.
So a reverse yield curve on the repo market is a sign of illiquid stressed banks and a looming credit deadlock/crunch.
As I said the existence of this condition alone blows PTP theories of interest out of the water as interest rates can be shown to be set by a complex interaction of profit and risk expectations and the profitability/liquidity of lenders.
I have been searching for any explanation of inverted yield curves within PTP and ABC (Austrian Business Cycle) theories – I cannot find any.