Money markets matter

Just tell me whether the market�s going up or down!� It was January 2001, and George had bought technology stocks for his clients in 2000 at the peak of the Internet bubble. He needed those trades to at least break even before his next reporting period ended. He really wanted to hear some good news about the outlook for stocks. �But the spread between the three-month and the 10-year is positive!� he wailed. He felt entitled to a stock market rally; in fact, his job depended on it.

The yield curve, however, was not normal from three months to one year. Most people do not pay much attention to these very short-term securities because they usually have the smallest return; they do, though, have a large impact on the financial markets, the economy, and your investments. These are money market instruments.

Money market securities mature within one year and include both corporate and government instruments. In fact, every fixed-income security of any length eventually falls into this category as it nears maturity. If you buy a 30-year Treasury bond and sell it after 29 years, your broker executes your trade through the money market rather than the bond-trading desk. We can get useful information about the economy and the stock market from both corporate and government money market instruments.

Some economists pay special attention to yield curves in a segment of the corporate money market, commercial paper. Commercial paper is an unsecured debt of, or a good-faith loan to, the corporation that matures within 270 days and usually comes in round lots of a million dollars. This paper appeals to large institutions such as mutual funds because, while only the highest-quality firms are able to borrow in this manner, they still must pay more than the U.S. Treasury pays. You probably own more commercial paper than you think because so many banks, insurance companies, and mutual funds buy it for your accounts.

Economists see commercial paper as a window into the issuing firm�s order book. The commercial paper yield curve is one place where we may be able to see into the cash flows of the firm. To oversimplify, let us say that General Electric (GE) does not expect to sell a lot of lightbulbs in the next six months. The company therefore may not pay a high interest rate on short-term commercial paper it issues for fear of attracting money to that part of the yield curve. If the GE treasurer thinks that interest rates will decrease over the next six months, he offers an even lower rate and his yield curve slopes downward even more. George�s problem was that the treasurer at GE saw customers cutting the night shift at their factories and GE�s lightbulb order book was drying up. The treasurer thought that interest rates might decline during the next three months as well, so his yield curve sloped steeply downward. GE�s yield curve probably inverted like that shown in Figure 3.2, created from historical data on the Federal Reserve Bank of New York�s web site at Commercial paper and other money market interest data are in the financial press and on the Internet every day.