The Business Perspective

In normal times, a business has no trouble accessing credit from banks, and would be able to take out short term loans at a lower interest rate than it pays on long term loans.

However, when economic conditions deteriorate, the same business will find it increasingly difficult to borrow from its banks. This is due to banks becoming more risk averse, and charging higher interest rates to compensate for the higher level of risk.

More importantly, as conditions sour, more and more companies will find themselves unable to generate the same amount of revenues as before. As more struggle to generate the amount of sales needed to cover their costs, more start to borrow money from banks to meet their liabilities.

This increase in demand for loans also drives interest rates higher, to the point where it becomes more expensive to borrow money in the short term than the long.

If we were to interpret this using the perspective of uncertainty over a loan getting repaid, it means that banks think that businesses are more likely to default in the near future than over the long term.

In other words, a crisis is imminent. 

Put another way, demand for money is higher during times of economic stress, even as banks’ risk aversion increases.

The result? Tighter liquidity conditions and increased difficulty in obtaining debt financing as rates increase and creditors impose more stringent requirements.

Note that interest rates don’t always move in the same direction as we expect them to.

A good example would be when USTs sold off for a period of time at the height of 2020’s panic. This ran contrary to conventional thinking, which believes that “risk off” periods entail falling yields.

In other words, in times of crisis and uncertainty, yields should be falling as everyone rushes to buy USTs. Yet in that period of time, UST yields rose in the middle of a panic the scale of which the world had not seen since 2008.

Suffice to say that it is important for you not to hold on to fixed and preconceived notions of what rates will do at any one point in time.

The Repo/Collateral Perspective   

Now let us put this in context of the UST yield curve, with an important extra bit of information added in. Which is that USTs are themselves money. Not money in the conventional understanding, but money as collateral for trillions in transactions undertaken in the global repo market.

Hence, the example given above, of businesses and loans, translates directly to the yield curve. In place of businesses, we have financial institutions (banks, hedge funds, pension funds, asset managers etc), and instead of bank loans we have collateral.

Consequently, the shape of the US yield curve directly reflects the supply and demand for USTs as collateral, which are the lifeblood of the global repo market. 

Returning to our simple example of businesses and loans, the first, “normal times” scenario describes a regularly shaped US yield curve.

The higher inflation is expected to be in the long term, whether due to economic growth or shocks, the higher longer term interest rates will be. This in turn causes the yield curve to steepen, as rates at the long end rise faster than those at the front (short end).

In the wider economy, money is easily available (remember, money supply is loan creation, not bank reserves as loans are easier to come by.

In the repo market, collateral is widely available as confidence flows through the financial system, and concerns over counterparty defaults aren’t high on the list of concerns.

When the economy turns and conditions deteriorate (the second scenario in the business/loans example), expectations for growth and inflation fall. Uncertainty also rises as banks and repo market participants start to grow more wary of the risk of their trading partners defaulting on their borrowings.

As a result, an increasing number of traders and investors prefer to hold on to their USTs in order to ensure they have enough for their own use should a crisis unfold.

Put another way, folks start to hoard collateral. (The same way banks hoard loans when they are risk averse by lending less and with more stringent requirements)

The natural consequence of this behavior is higher UST prices (lower yields) as market demand for collateral increases while people who own them grow more and more reluctant to sell.

It is important to note that this hoarding occurs at all points of the yield curve, but most noticeably at the short end. This is due to T Bills being the most pristine, and thus most desirable form of collateral.

However, while long end yields experience less of a collateral hoarding effect, they are much harder hit by the repricing of inflation. As growth prospects diminish along with long term inflation expectations, many investors will seek to “lock in” yields while they are still high.

They do so by purchasing longer dated USTs, driving their yields lower. If they come down faster than short end rates, the yield curve flattens.

To be continued…