On February 8 the US Yield Curve inverted, which means that short-term interest rates are now higher than long-term rates. At the moment, the US Yield curve is inverted by about 19 basis points, or .19% percent, from the 2 year to the 30 year treasury bonds.
There has been a lot of market talk lately about the inverted yield curve, and what it means for interest rates and the economy. This worry comes from the oft quoted fact that every US recession since 1960 has been preceded by an inverted yield curve.
Today we will try to make some sense of the yield curve and what it may tell us about the future. Although there are many theories out there about interest rates and the reasons for the current shape of the yield curve, including those by the current and former Federal Reserve chairmen, economists, and market analysts, no one knows for sure. Nevertheless, we hope to provide some insight into this interesting phenomenon.
First let’s review the definition of the yield curve. It is a graphical representation of yields at different bond maturities. The US Government issues bonds that mature in 1 year, 5 years, 10 years, 20 years, and most recently reintroduced the 30 year bond. “Yield” loosely refers to the Yield to Maturity which is the total return an investor would expect to receive if she bought the bond today and held it to maturity.
When you plot the yields of these maturities from 1 to 30 years and connect the dots, the shape of the line is normally upward sloping; meaning investors must be paid higher yields for lending for longer time periods. When the curve is inverted, investors are being paid more to hold bonds of shorter maturities. So what gives? What can account for this anomaly?
The classic explanation of why inverted yield curves precede recessions is that they reflect economic pessimism of bond investors. Investors purchase long bonds to lock in relatively low rates in anticipation of a worsening economy. The demand for long bonds pushes up prices and consequently lowers yields.
So, with short rates even slightly higher than long rates, who is buying longer bonds? Why not just buy one or two year treasury notes, and roll them over when they come due? In spite of the yield curve inversion, there are three natural buyers for longer bonds: 1) investors who think short rates are going down in the near future, and want to lock in higher rates now; 2) duration buyers, those investors who need long duration fixed income assets to match liabilities; and 3) foreign governments, who are recycling export dollars by investing in US government bonds.
In fact, since the yield curve is only slightly inverted, perhaps the more important question is “why is the yield curve so flat”. This is the issue Alan Greenspan was referring to when he spoke of his now famous “conundrum”.
Now to answer the question we asked at the beginning:
In the current environment, we do not feel a flat, or the slightly inverted yield curve is forecasting a recession. As we will discuss, there are a number of other reasons to explain the shape of the yield curve.
While we recognize that cries of “it’s different this time” will frequently get you in trouble, are some of those reasons:
• Real interest rates are low by historical standards. In past times of yield curve inversions, yields have been much higher. Low rates keep the cost of capital down for corporations and the cost of credit down for consumers. All else equal, low rates are a positive for economy growth.
• Liquidity is high as a result of an accommodative Federal Reserve managing liquidity in the “post bubble” era since 2000. Market liquidity means ample availability of credit. In past times sudden tightening of credit has coincided with higher rates, and may have been the real cause of the recessions associated with inverted yield curve. At the moment, we don’t see a contraction in credit conditions.
• Foreign companies, investors, and central banks in countries like China and Japan, who are running large trade deficits with the US, are recycling those dollars by investing them in the US treasury market, the largest and most stable bond market in the world. The broadening economic growth in Asia and oil related capital flows to the Mideast has reinforced this trend. This creates demand for treasuries and allows yields to remain low.
• Finally, there is some evidence that inflationary expectations are low, driven by globalization, technology and productivity, and the rise of emerging market economies which keep costs low around the world. Since inflation lowers real returns on bonds, bond investors will accept lower yields in a low-inflation world.
Does this leave US interest rates vulnerable to foreign investors suddenly losing interest in US treasuries? It certainly does, though I will say I have heard this fear expressed many times over my investment career, while foreign ownership of US treasury bonds has only continued to rise.
So as we have described, there are a number of reasons that explain the current inversion and flatness of the yield curve other than investor pessimism.
So we draw two conclusions: First, it appears that during this interest rate cycle, the yield curve is flatter than in the past and interest rates are lower, and Second we think the shape of yield curve is no longer as strong a predictor of future economic growth as it has been in the past.
How long will the curve stay flat or inverted? Perhaps that’s a good topic for a future call, but if this does turn out to be a new paradigm, chances are something unforeseen will come along to change the shape of the yield curve yet again.
