What's Going On With Interest Rates?

The calamities in the financial markets can be summed up by one simple statistic. On September 17, the yield on three-month Treasury bills fell to 0.03 percent, a rate not seen since the Great Depression. It was a stampede to the safety of government securities. Short-term yields recovered somewhat by the end of the month but are still far below their level of two years ago, when the yield curve was inverted.

It has been called a liquidity crises but liquidity is not really the problem. There is still plenty of money available but lenders have little confidence that debts will be repaid. The spread between Baa-rate corporate bonds and 10-year Treasuries increased to almost four percent. Even the relatively low risk LIBOR market was affected, as rates shot up almost 150 basis points, a troubling development since so many adjustable rate mortgages are tied to this rate. What this really means, however, is that credit markets are still working as they should, with yield spreads reflecting perceived risks of default. Inter-bank loans are considerably more risky than they were just a few weeks ago.

For the foreseeable future, Treasury yields will remain low but that will be of little help to borrowers seeking funds. It is a classic case of “crowding out” in which money flows into government debt and away from private sector investment. And less business investment today means less economic output in the future – a polite way of saying that the US economy is in recession.