Understanding the Inverted Yield Curve

There’s been a few comments intimating that, well, maybe an Inverted Yield Curve ain’t so bad. I have to disagree in the strongest possible terms. And I have three decidely non-textbook reasons as to why:  Cyclical, Liquidity, and Predictive factors.

Cyclical Factors: At the end of a recession, the Fed will have
already been cutting short rates. The curve will be rather steep at that
point in the business cycle — and not coincidentally, its when and where an expansion is most likely to occur.

Conversely, when the curve inverts, its at the
opposite end of the wheel — when the economy has been heated up for a while, after an expansion, after a round of Fed tightening.

Liquidity: A steep yield curve is stimulative. Its because there’s so little return for investors at low rates — by cutting rates, the Fed essentially encourages any investment alternatives to bonds. Capital holders (investors) look to put their cash to work elsewhere; That capital investment tends to be broadly stimulative.

Predictive Bond Market:  Regardless of what factors contribute to the yield curve inverting, it
is essentially a collective expectation by the Bond Market that even
LOWER RATES ARE IMMINENT — in other words, lock in rates NOW while you
can.

Why else would investors take a LOWER INTEREST RATE ON LONGER TERM LOANS THAN SHORTER TERM? You tie cash up for longer, there is lengthened risk, plus the opportunity costs — the loss of the use of that capital for other potentially lucrative investments.

Why might rates get worse? Its the expectation by very smart money of a WORSENING ECONOMY and all that entails.

Its essentially an economic bet — that this is the last chance to lock in mediocre rates before they get much worse. Someone else described (cant remember who) as "A chance to lock in rates before the bottom falls out."

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If you would like to see specific examples of yield curves from varying years and how they played out there’s an excellent primer at Smart Money that’s well worth reading:  The Living Yield Curve

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  1. Blackwood commented on Aug 20

    This is leaning to a “The Intelligence of Crowds” theory that the aggregate decision of many individuals is smarter than a few educated institutional investors.

    A peek at the treasury site will show the major foreign investors:
    http://www.treas.gov/tic/mfh.txt
    including the now infamous “Caribbean Banking Centers” which no one knows where their money is coming from. Drug Cartels? Iraqis? Iranians betting on the US invading them soon? Only a few island bankers know.

    I think we’re seeing a competition between the foreign money on the long end like Japan, which has a huge preference for long term bonds even when it there is no finacial advantage in doing so vs the US locals on the short term end who, conditioned to buying CDs at their bank since the 1980s, will use Treasury Direct to buy 90 day T-bills whenever the rate is the same as what bank CDs are offering and save on their taxes as a result.

    Why do the Japanese buy 20 year bonds when the yield on a 5 year is essentially the same? Because their institutional consensus process is so difficult. Once management finally gets an institutional decision made, the idea of not having to revisit that process for another 20 years instead of in 5 years is quite appealing, even if the rate return is exactly the same.

    Why do US locals prefer 90 day T-bills over longer term notes even when those notes are paying out more? Too many other choices. No one else in the US is offering a commission free 90 day investment outside Treasury Direct. But at the 6 month and longer periods no one puts their money in Treasury Direct because it’s pretty hard NOT to find someone paying a better rate for these longer periods.

    So who’s smarter –the US consumer who’s conditioned to shop for the best rate each time their CDs mature but is loathe to buy anything longer than 90 days from Treasury Direct, or the Japanese institutional investors on the long end doing the same thing they always have been doing.

    Or is it really even a competition? Could it be a bifuricated market with no connection between the two? A narrow curve could serve the two different markets fine. If the US Treasury wants to increase domestic ownership of the national debt the magic number is 3.5% and above on 90 day T-bills. Meanwhile the Japanese investors frankly don’t care about the five year and 20 year rates being the same as long as they don’t have to go through their consensus process often.

    It’s quite possible the two ends of the market are too split for it to be a very good indicator anymore.

  2. nate commented on Aug 20

    Somebody on Prof. DeLong’s blog had a hypothesis that the Caribbean banking centers are hedge funds.

  3. Blackwood commented on Aug 21

    Interesting to look at the other national bond rates as well: The U.K., Japan, German and Australian bonds are all also in narrow yield curves, some even more narrow than the US. The sole exception Brazil… is hardly the country you want to model economicly…

    http://www.bloomberg.com/markets/rates/index.html

    Also interesting is the absence of one of the largest holders of US securities, China itself. China’s internal bond market has been awash in fraud, manipulation and rip offs propogated by its own government officals. The only way China has successfully issued bonds on the international market are not in its own currency, but in US dollars and pegged to US treasury return rates. Which means devaluating its own currency is REALLY going to screw themselves over. http://english.people.com.cn/200310/30/eng20031030_127183.shtml

  4. Econbrowser commented on Aug 26

    Recession in 2006-07?

    If you just extrapolate the dynamics of past economic expansions, you’d say that a recession within the next few years is quite possible but by no means certain. The question is how much weight you want to attach to some of the other factors.

Read this next.

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