The Interest Rate Banana Your Stocks Will Slip On.

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 

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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 Signals 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 ratesmean 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?

Murray Dawes has spotted another banana skin your stocks are heading for. He’s calling it Big Wednesday, and he’s found a way to profit from it:

But which way? Up or down? Click here to find out.

Nick Hubble
Editor, Money Morning.

This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter.