Yield Curve Shape: What it tells & WHY?

Discussion in 'Business & Economics' started by Billy T, Mar 11, 2006.

  1. Billy T Use Sugar Cane Alcohol car Fuel Valued Senior Member

    What is an inverted yield curve indictating? Good times, bad times or something else?

    Statistically, it has been an fairly reliable indicator of coming recessions. Is this time different?

    It seems clear that the US will be going deeper in debt for some time. (Assumption 1) This implies that Treasury will issue ever more bond & notes annually. (Assuming US wants to avoid the "run-a-way" inflation that would result if the mint simply prints more money to meet the government's needs.)

    Treasury issues are subject to laws of supply and demand. Thus, if the demand is assumed to be constant, then assumption 1 implies the price of the all treasury notes & bonds will fall and interest rates will correspondingly rise. The demand could increase and then this need not be true or demand could decrease and then the drop in value and rise in interest rates would be even greater.

    Demand is not insensitive to time. For example if increasing inflation is expected, but not too bad at present, there can be great demand for short term notes yet little demand for bonds (Notes have no more than 5 years to maturity). A decreased demand for long term bonds will lower their price and increase interest rates at the "end" of the yield curve. This "normal" yield curve is also caused by the simple fact that money which will return many years hence is not as valuable as money which returns next year. Thus, the current purchase price of a $10,000 / 30 year bond will normally be less than the price of a $10,000 note and this "discount fact" does not indicate any increasing inflation expectation. It only indicates how much the future value of money is "discounted" to present value.

    In view of the above, the flat or inverted yield curve would seem to indicate that investors are not making even the normal discount of the future. Inversion would surely seem to imply that investors are not expecting inflation to increase significantly as this combines with the discount of the future to make the yield curve even steeper. Hence it seems safe to assume (Assumption 2) that investors are not currently expecting growing inflation, despite the growing US debt, which could normally cause significant inflation. Why might that be?

    Possible answers:
    (1) The Fed, under Greenspan, has demonstrated the ability to control inflation and more governments (even those like Brazil, where double digit monthly inflation was recently common) are now using "inflation targeting" policies. - Adjusting interest rates they can control, bank deposit requirements, etc., to limit inflation well below double digit annual rates.

    (2) The world is "flooded with money" because following the IT bubble burst of a few years ago, many central banks feared economic recession and greatly eased credit. This "excess liquidity" funded both record levels of Foreign Direct Investments, FDI, in China and other less developed countries (i.e. the BRICs, etc.) and sought shelter in Treasury bonds, driving the price up and interest rates down. In this view, it could be more that short term rates are high than that long term rates are low, which causes the relatively flat yield curve.

    (3) Many financial institutions, such as insurance companies, pension funds etc., have very foreseeable and distant financial needs, which they want and need to offset with long term stable assets, such as 30 year US bonds; however, for past three years no 30 years bonds have been issued. Only a decreasing supply of older issues were available in the secondary markets. This supply shortage, drove the price up and interest rates down at the long end of the curve. Some support for this view can be found in fact that the recent resumption of 30 bond sales was very popular and over subscribed.

    I think Asumptions 1 & 2 are both valid, but refute them if you can. Surely there are other ideas & explanations why, despite the rapid growth of the US's "twin deficits," the yield curve shape is not indicating that investor expect an inflation surge. I would like to hear them because, I am currently leaning towards:

    (4) This time is not different. Investors are wrong. Inflation is going to return and with it the high interest rates, which will crush the economy, especially the housing market, were many have withdraw their equity and spent it. I.e. once again the inverted yield curve is forecasting bad times ahead, despite the "rationalizations" of (1), (2) & (3) above.

    What do you think, and why?
    Last edited by a moderator: Mar 11, 2006
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  3. Billy T Use Sugar Cane Alcohol car Fuel Valued Senior Member

    This more than 3 years old thread never got even one reply, but the question it asks is even more important today when now the yield curve is growing steeper every week, not inverting as it was when thread was created.

    BTW, I have concluded my answer (3) in the OP was the dominate cause of the inversion.
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  5. joepistole Deacon Blues Valued Senior Member

    I am sorry Billy T, I do not have a lot of time to answer your question. Just as a inverted yeild curve is predictive of an economic slow down; a steep yeild curve is indicative of an economy in recovery.

    Additionally, inflation is much more than a monetary event. Inflation occurs when aggregate demand exceeds aggregate supply or aggregate supply exceeds aggregate demand, you will have inflation. In one case one has "cost push" inflation and in the other "cost pull" inflation.

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  7. Billy T Use Sugar Cane Alcohol car Fuel Valued Senior Member

  8. kmguru Staff Member

  9. 2inquisitive The Devil is in the details Registered Senior Member

    I think trying to hold a 3%, or even 4%, yield on 10-year notes is unrealistic. Until the reports of high mortgage defaults began in fall 2007, starting the financial crisis, yields averaged around 4.5%. In the fall of 2007, investors began pulling their money out of Mortgage Backed Securities and into the safety of Treasuries. The influx of new moneys and demand for treasuries led to fall of yields to much below normal. The events of Nov. 2008 caused treasury yields to fall of a cliff because of the exit of equities and about everything else. Money is now going back into equities and out of low-yielding treasuries. The huge amounts of treasuries being auctioned to finance the budget deficit and bailout also increases yields. I see no way yields can stay low, below 4.5%, because of the decreased demand and increased supply. All of this is shown on any bond chart that tracks yields over a several year period. Here is a link to kmguru's charts for five years, if the link will show that specific chart. If not, simply click the 5y tab at the bottom of the chart:
  10. Billy T Use Sugar Cane Alcohol car Fuel Valued Senior Member

    I think you are correct in this (and the rest of your post). The point is that the FED can not keep interest rates lower than normal (to stimulate) and at the same time, load up on Treasuries, which all know it must sell later to avoid run-away inflation, if and when the economy recovers.

    Perhaps "recovers" is not the correct term if US enters depression but the velocity of money has rerturned to even above normal. - I.e. everyone is quickly spending their money (buying) before their dollars loses even more value. "Stagflation" is then the correct term, and what I expect. I.e. I think the FED is losing control of the economy (value of dollar now and velocity of money soon).

    My paper today tells that net FDI into Brazil in 21 days of May, just for buying stocks, was 4221 million dollars. The Brazilain DOW is up 38% since start of 2009. FDI in April for buying companies etc. was 3409 million dollars and since start of year til end of April was 8751 million, but that is down from corresponding period at start of 2008 by 31%. In first 22 days of May the central bank has bought 2408 million dollars but vs the real, dollar has fallen 39%, in 2009 to only R$2.018 yesterday. (Central bank only started to buy $ about two weeks ago. I think R$2/$, may be their "line in the sand.") Certainly the appetite for "risk" is returning to investors now but many must think holding dollars is higher risk than investing in Brazil.

    Later by edit: Today the "line in sand" was slightly crossed. Bloomberg confirms my papers numbers, but not a precise as in the paper. See: http://www.bloomberg.com/apps/news?pid=20601083&sid=aLKJn5BL.SMk&refer=currency

    Also not that now with the stronger Real, the inflation rate is expected to fall below the target and give room for more reductions in interest rates - more stimulation for the economy & increase in GDP growth rates. Brazil is doing very well, thank you.
    Last edited by a moderator: May 27, 2009
  11. Billy T Use Sugar Cane Alcohol car Fuel Valued Senior Member

    Just minutes ago Bloomberg put up:

    "... yield curve steepened to 2.75 percentage points, {10yr -2yr rates} surpassing the previous record of 2.74 percentage points set on Aug. 13, 2003. Yields on 10-year notes have risen more than 100 basis points since Fed officials said in March they would buy up to $300 billion of U.S. debt over six months ... The markets are starting to grapple with the issue of what happens when the Fed exits and the Treasury needs to continue at the same pace,” said David Greenlaw, the chief financial economist in New York at Morgan Stanley,

    U.S. 10-year notes have lost 8.7 percent this year, according to Merrill Lynch & Co. indexes, while 30-year bonds have lost 25.5 percent. Two-year notes have gained 0.3 percent. Investors are selling long-term Treasuries as the government borrows record amounts of debt to fund bank bailouts, stimulus spending and a record budget deficit. The U.S. will sell $3.25 trillion of Treasuries in the fiscal year ending Sept. 30, according to primary dealer Goldman Sachs Group Inc. ..."

    From: http://www.bloomberg.com/apps/news?pid=20601087&sid=aYHa.5_QudRo&refer=home
    Last edited by a moderator: May 27, 2009

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