Wednesday, January 17, 2007

More on Interest Rates

There is a corollary that can be drawn from yesterday's post about the influence of derivatives on longer-term interest rates (my opinion is that explosive growth in credit derivatives helped keep rates down even as debt kept shooting up).

Here it is:

As Credit Default Swaps (CDS) and other such derivatives become less popular and/or more expensive, borrowing costs will rise, i.e. interest rates will go up. I am referring to longer rates (5 years plus) and those for less credit-worthy borrowers. In market lingo, the yield curve will steepen on the long end AND credit spreads will widen. This is a double whammy, particularly for the mortgage, LBO, hedge fund and private equity business. The fact that those are exactly the sectors that have been so hot during the past 3-4 years is not at all a coincidence.

This means that even if the US economy slows down further during 2007, such interest rates could still rise or stay roughly the same, even if credit demand drops sharply. This is obviously contrary to the conventional wisdom that has rates dropping during a slowdown. But then again rates did not go sharply higher during the recent expansion either. The extra boost of credit derivatives during an expansion could turn into a drag during a slowdown.

I have been very vocal in saying that in commodities - oil in particular - it is the tail (derivatives trading) that has been wagging the dog (cash prices) for at least 12 months now. This could also happen in the more sedate bond business....

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