The Australian Bureau of Statistics has done it! That's an odd statement in itself, but how about this next one: the statisticians have saved us all! How? By completely bungling employment data for the last two years, to the tune of 100,000 jobs. Apparently, the mistake tricked the Reserve Bank into interest rate moves. And now those moves are benefitting, as politicians would say, the working-family-fair-dinkum-Aussie-battler.
Australian house prices jumped a percent last month because of lower mortgage rates. And, according to the papers, it was the inaccurately pessimistic jobs data that made the RBA cut interest rates. Either way, home owners are now 1% richer. Except they still have exactly the same houses. Hmmm.
At least the price jump should offset the recent news in The Age that the, 'Housing shortage [is] all smoke and mirrors', and the number of vacant homes is just under a million.
Before you get too optimistic about lower interest rates saving the Australian economy, consider this: The Australian yield curve looks like a banana. That's a very bad thing.
Australian Government Bond Yield Curve
Or, if you prefer:
Yield curves are supposed to look more like this one, the German one:
German Government Bond Yield Curve
So what's bad about a yield curve shaped like a banana? The short answer is that a banana shaped yield curve predicts a recession, or at least a slowdown in growth. If you own shares, you'll want to factor that into your expectations.
Remember, in 2008 a recession took place on the other side of the world, and Australian stocks halved. Imagine if the recession took place here.
How Interest Rates Signal Time Preferences
To get to the bottom of what the yield curve really means, we'll begin with former math teacher Angela Lee Duckworth. Angela did an experiment with eighth graders. They 'were given a choice between a dollar right away or two dollars the following week.'
That's like offering them an annualised interest rate of around 5200%, or 100% in a week. You'd be a fool not to take it, right?
The New Yorker magazine explains that Angela 'found that the ability to delay gratification...was a far better predictor of academic performance than IQ.'
Notice how the 5200% per annum interest is the key measure in deciding whether or not to delay gratification. If Angela had raised the bar to choosing between a dollar right away or two dollars fifty next week, more of the eighth graders would have agreed to delay their gratification because they would be getting a higher interest rate (7,800% p.a. or 150% per week). That would sweeten the deal for waiting.
In other words, the interest rate is the price of delaying gratification, or the reward for delaying your gratification. In the financial world, the reward comes about by saving and then lending a dollar for interest.
The interest rate is also what you miss out on for refusing to delay your gratification (by consuming instead of saving and lending). And it's also the price you pay for using the gratification someone else has delayed (by borrowing their savings).
Putting all those statements together, you realise this: The interest rate is the price of time.
Understanding how the interest rate signals to the economy the state of delayed, present and future consumption is the secret to understanding and predicting the world's current economic malaise.
So what determines the interest rate? The same factors that determine every other price in the economy: supply and demand. When people save, they increase the supply of money that can be lent. The people who want that money are the borrowers. The interest rate is the price that matches the savers and borrowers. The good they are REALLY dealing in is time — the point in time at which the money gets used.
So what do high and low market interest rates mean? Low interest rates mean there are plenty of people willing to save. They value present consumption only a little more than future consumption, and so are willing to delay it for a cheap interest rate. A high rate means people aren't willing to delay their gratification unless there's a large reward — a high rate of interest.
Australia's Yield Curve
Taking a look at Australia's yield curve, what do you see?
Probably not much, unless you know what a yield curve is, so here's an explanation. A yield curve shows the interest rate paid on debt of different maturities. If you can borrow money from the bank for one year at 5%, two years at 6% and three years at 7%, your yield curve would be a straight upward sloping line connecting those three dots on a chart.
Because government bonds are risk free (theoretically), the government yield curve is the purest one available for an economy.
Look at Australia's government bond yield curve. Market interest rates are high for the government to borrow for 3 months, lower for three years and steadily higher after that.
Australian Government Bond Yield Curve
You could say that, over the next three months, people aren't that willing to delay their consumption. They want a high reward for saving and lending to the government. But go out three years, and people are quite willing to hand over their cash for a much lower interest rate. They are quite happy to be a saver and lender — a consumption delayer. Go out fifteen years and people want to consume again. They need a high interest rate to part with their money.
Now why would someone be willing to delay their consumption more or less for different time periods? Why might they prefer to save over some periods and borrow over others? Perhaps because they are worried about the state of the economy at certain times in the future. They are happy to spend when times are good and afraid to borrow when they are bad.
With Lower Interest Rates Prepare for a Slowdown
So lower rates show people are worried about the economy — they choose to save more and borrow less. Right now, people are worried about the next two to five years, for example. After that, they expect things to go well and their consumption and borrowing to rise.
We've isolated just one factor involved in a yield curve. There are many others. Not all borrowing is for gratification, for example. Some of it is for investing in production. And interest rates reflect other things, like inflation, in the real world. People might just expect inflation to fall for the next few years, which would also reduce rates.
If you focus on the delayed gratification side of things, the banana shaped curve tells you that a significant slowdown in borrowing and consumption is coming to Australia. Is your portfolio prepared for it?
Before we even had time to ponder that question, BAM:
'In a 45-minute span, the European Central Bank and People's Bank of China cut their benchmark borrowing costs, while the Bank of England raised the size of its asset-purchase program.'
That's right, the interest rate isn't the pure, innocent, honest price we've made it out to be. In fact, if you throw in the recent revelations of LIBOR manipulation by private banks, the interest rate is an undiscerning lady of the night. Happy to sell herself to the highest bidder, public or private.
So how does this fit into our story of the bananarama yield curve? Easy: time travel.
When Time Travelling Central Bankers Manipulate the Interest Rate
So the interest rate is really the price of time. It matches those who want to delay their gratification (savers) with those who want to gratify themselves now (consumers), and those who want to gratify themselves beyond what they've got (borrowers).
Interest rates fall when people are more willing to save and rise when people want to consume and borrow.
But what happens when central banks start fiddling around with this delicate balance? What if they start to manipulate interest rates? Disaster!
Normally when governments mess about with prices you get a straight-forward disaster. If they set the price too high, they get a surplus of production and not enough consumption (think European farm subsidies). If they set the price to low, they get a shortage of production and a surplus of consumption (think Richard Nixon's price controls).
But central banks don't just set the price of time - the interest rate. They intervene in the actual supply of time. That's right, central bankers time travel! At least, they induce time travel. They bring forward consumption from the future, or push back consumption from the present. Usually it's the former to make present economic growth, and themselves, look better.
How do they achieve this time travel? Well, they push down the interest rate by printing money and injecting it into the economy. They create fake savings. That lowers the interest rate, as more money is available for borrowing. Lower interest rates turn savers into consumers and borrowers because they get less reward for saving and borrowing is cheaper. This means more present consumption. But with less real savers, and less real savings, there will be less consumption in the future. Less people are actually delaying their gratification. Future consumption is reduced and present consumption is increased.
Two other things happen. The remaining savers earn less interest, because of the lower rate. And the increase in the money supply, which reduced the interest rate, eventually leads to inflation. Both of these decrease the amount of gratification a saved dollar will buy in the future. Those who did save to support future consumption are robbed of their purchasing power.
All this adds up to less consumption in the future. It was stolen by the central bankers of the present. Each time they create money to inject savings, it steals more prosperity from the future.
Here's our conclusion - the golden thread that connects the dots:
Manipulation of interest rates around the world brought forward consumption from the future for many years. But we are now in that future. The world is realising that present consumption is not enough, because it was stolen by the time travelling central bankers of the past. There's not enough consumption left to steal, especially in places like China, the US and Europe. Not that the central bankers aren't clutching at straws anyway. They continue to implement the same interest rate and money supply manipulation policies, but with less of an effect each time.
That's why, in Australia, the yield curve is telling you there's a recession and deflation coming. Europe, America and, worst of all, China are slowing down. How do you avoid slipping up on the banana?
Greg Canavan has figured it out. And, between you and us, we're on the way to the other side of the world as you read this, in an effort to implement his advice.
Find out more from Greg directly, here.
Until next week,
The Daily Reckoning Weekend Edition
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About the Author
Nick Hubble is feature Editor of The Daily Reckoning Australia – weekend edition. You can subscribe to the Daily Reckoning for free here. Nick has spent the last three years discovering lots of new, exciting and surprisingly simple ways to generate money for retirement. He’s put all these ideas into his investment publication The Money for Life Letter. If you're already a subscriber to these publications, or want to follow Nick's financial world view more closely, then we recommend you join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.