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The Yield Curve and the 3-6-3 model

The Yield Curve

The private financial system makes money by borrowing short and lending long. They can do this by taking advantage of a normally sloped yield curve. This is the bankers old 3-6-3 model. "Borrow at 3% lend at 6% and be on the golf course by 3pm"  Banks make a profit by loaning out money as fixed rate mortgages, that they fund with money "loaned" to the bank in the form of deposits, money-market, accounts and CDs  (short-term liabilities). This creates a maturity mismatch. Normally this is a safe bet, because the yield curve is usually normally sloped upward as shown above.  When the yield curve becomes inverted - the bank gets hammered, therefore the maturity mismatch is a risk to the bank.

 

(From the Economist)

1) An inverted yield curve, then, suggests that short-term rates are higher today than they will be in the future. But why should this necessarily spell recession? Normally, it is because the Federal Reserve is in the midst of a campaign against inflation. To win this battle, short-term rates are sometimes raised high enough to induce a recession, which squeezes inflation out of the system. In due course, lower inflation will pave the way for lower short-term rates. But before this happens, long-term bond yields fall in anticipation of the future victory. In this case, an inverted yield curve is just a measure of the Fed's power.

2) Alternatively, inversions may be a measure of the Fed's ignorance. The bond market may know something the central bankers don't. Long-term rates may be subdued, because the market anticipates a recession that will eventually force the Fed to loosen monetary policy. But short-term rates remain high, because the Fed has yet to act on what the bond market foresees.

When no one wants to lend long, governments can fill the void buy borrowing short term money and using it to buy long term bonds. The US is currently doing this. The US has been loaned a large some of money at near zero interest rates, loaned to them by the fear trade. The US is currently buying down the long end of the yield cureve buy buying longer dated treasuries and some mortgages. (This is partially true, the US is actually using both money from short term notes they have issued and also from currency they have conjured up (printed.)