Larry, ever heard of the yield curve?

Larry Elliott, Guardian economics editor, makes a fairly silly statement:

The banks are not exactly helping King and his colleagues on the monetary policy committee; they are hoarding cash and rebuilding profits decimated by ill-judged investments in fancy derivative products by gouging their customers. Over the last two years, the bank rate has come down from 5.25% to 0.5%, but a two-year fixed mortgage has come down by 1.6 percentage points and a five-year fixed home loan by just 0.5 points. Unsecured loans are more expensive than they were before the crunch.

For while what he says is in fact true, it\’s not enough of the truth to tell people what is actually happening. For there is something called the \”yield curve\”.

Here\’s the chart for this morning, lifted from the FT.

\"yield-curve\"

Now, this isn\’t exactly the same as the rates at which banks lend to each other but it does give us a useful little clue as to what is happening.

That 0.5% bank rate is obvious over there at the left….but that, as the chart implies, only works for money borrowed up to 6 months. So, if you have a plain vanilla mortgage, that is indeed where the banks are getting the funding for it (remember, the definition of a bank is someone who borrows short and lends long). For they can borrow the money at this 0.5% rate for a month and lend it to you. Then next month they borrow it again, at 0.5%. If they have to pay 1.0% for it next month, they\’ll raise your mortgage payment. This is what a floating rate loan means.

However, if you want to borrow for longer than 6 months then you have to pay more. Might be people worried about repayment that far in the future, might be worries over inflation, can and could be all sorts of reasons: but if you want to borrow 10 year money then you\’re paying 4%, not 0.5%. This is of course 4% for the whole period of ten years, that\’s what you\’re doing by agreeing to the time term, fixing the rate for that term.

Note also please that these are wholesale rates, not retail: you\’ve got a whole level of offices, loan officers and bank managers to pay for on top of these before you get to what we might be charged as individuals.

Of course, when banks offer fixed rate mortgages, they do not fund them from those short term borrowings at 0.5%. That\’s the sort of thing that is very frowned upon: it leads people to going bust, borrowing both short and floating rate and lending long and fixed rate. So the banks will borrow two year money to fund two year fixed rate deals: five year to fund five year.

As you will note, two and five year money is more expensive than 6 month money.

Thus fixed rate mortgages are, in the current climate, more expensive than the base rate.

We would normally expect this to be the case although it can happen that the yield curve inverts. That borrowing longer term is cheaper than short term. Indeed, I have a feeling (from dim memory, not something I would want to have to prove) that this was indeed the situation before the crash, that long term money was cheaper than short.

All of which means that by comparing fixed rate mortgages now to base rate now Our Larry is rather muddying the picture. What can and should be compared is two year money then to two year money now, five year to five year and base to base.

All of that is bad enough, Our Larry brandishing rates which he knows are not comparable (and if he doesn\’t know they\’re not comparable then he should be fired, pronto) to make a political point. It\’s also bad enough that I doubt very much that there is anyone within the Guardian\’s walls with enough financial knowledge to call him out on this.

But what\’s really bad about what he\’s done is that he\’s missed, as St Barack would say, a \”teachable moment\”.

Governments and central banks do not, as that chart obviously shows, control interest rates beyond the short term. Medium and long term interest rates are determined by the markets, not politicans and not bureaucrats.

Sadly, the reason why the exposition of this obvious truth is missed is because it argues against one of the dearest wishes of The Guradian\’s fiscally illiterate readership. That only if we had the government directing lending then industry (all those things you can drop on your foot that they rather oddly seem to like so much) would get that lovely cheap long term money it desires. But it won\’t, because the rate at which it will is not determined by government.

6 thoughts on “Larry, ever heard of the yield curve?”

  1. Well, historically the mortgage rate has followed the Boe Base Rate (or 3m money market rate) much more closely than the 10yr yield. But in any case the gap between the halifax’s SVR and the 10yr yield is higher than at any time since 1990, as far as I can see. See here

    http://www.flickr.com/photos/mjtphotos/3814425672/

    Tim adds: “historically the mortgage rate has followed the Boe Base Rate (or 3m money market rate) much more closely than the 10yr yield.”

    Err, yes, because fixed rate mortgages are a relatively new innovation in the UK market. Last decade and a bit really……

  2. “makes a fairly silly statement”

    Err, “a” silly statement? And no mention of big swinging dicks (he mentions them more than once: I think the man has issues).

    Reading his piece today, I knew Larry, dear dear Larry, would bring you out of retirement and back to making a post. I just knew it.

    “although it can happen that the yield curve inverts”

    And this normally a prediction of recession to come. Which it’s done fairly well this time too. Let us go back to Roger Bootle writing in 2006:

    http://www.telegraph.co.uk/finance/2933047/Economic-Agenda-What-is-the-yield-curve-telling-us.html

    Roger is quite temperate in his doom and gloom forecasts (he came in for some awful stick for predicting a housing market crash). Ambrose plays Cassandra more faithfully:

    http://www.telegraph.co.uk/finance/comment/2940848/Monday-view-Storm-clouds-gather-over-a-US-economy-heading-for-icebergs.html

    So the next time you hear someone say “no-one predicted this recession”, you need to say “bollocks” and point them at Roger and Ambrose. Archived on the net for all to see.

  3. The chart doesn’t show the fixed rate Tim, it shows the standard variable rate.

    Tim adds: “Now, this isn’t exactly the same as the rates at which banks lend to each other but it does give us a useful little clue as to what is happening.”

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