Sunday, December 13, 2009

The Yield Curve - Vega

In this issue:
1) Basic Theories of the Yield Curve
2) Basics In Action
3) What has the Yield Curve Told Us in the Past?
4) Is the Yield Curve "Smart"?
5) Chinese Demand

Dear Friends, Colleagues, and Investors:

The yield curve is the collection of interest rates offered by Treasury securities at various maturities (see graph below for current yield curve). The yield curve has historically provided a great deal of information about the future of the economy. The New York Federal Reserve regards it as a valuable forecasting tool in predicting recessions about a year ahead of time; it's been consistently more accurate at predicting recessions than professional economists over the last 30 years. Today the yield curve appears to be pricing in moderate growth and little inflation, while the equity and commodity markets appear to be pricing in robust growth and significant inflation. In this newsletter I'll explore the Treasury yield curve and explain what it's telling us today.

Please click on the link below to read the newsletter with all its graphics:

1) Basic Theories of the Yield Curve

The yield curve refers to the relationship between the interest rate on debt versus the maturity of the debt. For a bond, the higher the price, the lower the yield. There are a few different ways to think about the yield curve, each of which contributes to our understanding.

Pure Expectations Hypothesis: This simplistic view is that investors price each individual Treasury entirely based on their expectations for future short-term interest rates. So if the yield curve is sloping upward (i.e. if 10 year treasuries yield more than 2 year treasuries), investors must believe that short-term interest rates will be higher in 2 years.

Liquidity Preference Theory: This adjusts the "Pure Expectations Hypothesis" to take into account the fact that investors generally don't like to be locked into a long-term contract. Most investors will demand more yield to commit their money for a longer period of time. The Liquidity Preference Theory explains why the yield curve is usually upward sloping.

Preferred Habitat Theory: This more subtle theory acknowledges that investors sometimes want to hold debt for a specific amount of time. For example, a company may want to earn interest for 6 months until they must invest in a new factory. Alternatively, an insurance company may want to lock in a higher yield for 30 years to match the longer term liability of the life insurance contracts they provide. The Preferred Habitat Theory can explain any shaped yield curve.

2) Basics in Action
The yield curve is generally upward sloping. If investors expect inflation and short-term interest rates to remain steady, the yield curve will slope upward because investors value liquidity (as explained by the Liquidity Preference Theory). If investors expect interest rates to fall, the yield curve may be flat or even downward sloping (inverted). Investors will accept a lower return to lock in a yield for a longer period. For example, if short-term rates are currently 4% and the market expects rates to fall to 1%, you might accept a 2% rate of return over 10 years (as explained by the Pure Expectations Hypothesis). Throughout much of the 19th century the US experienced deflation so the yield curve was often inverted.

Beyond the shape of the yield curve, its absolute level gives us information about inflation expectations and risk aversion. If investors expect inflation of 5%, they’re likely to demand at least 6% return to loan their money to the government. If investors view the world as volatile and scary, they’re likely to accept a lower return in exchange for the safety of Treasury securities.

The effect of "Preferred Habitats" is more subtle. This point is debatable, but I believe that as China has become a large but reluctant buyer of treasuries over the last decade, their preference for shorter-term debt has reduced short-term rates relative to long-term rates.

3) What has the Yield Curve Told Us in the Past?

An inverted yield curve usually precedes a worsening economic situation. For example, in August of 1981, the yield curve was inverted, meaning that short-term interest rates were higher than long-term interest rates. The next year saw a severe recession and stock market correction. In April of 1992, the yield curve was steep with long-term bonds yielding 5% more than short-term bonds; the bond market was correctly anticipating robust growth and the stock market performed well over the next couple years. The graph below shows that the yield curve has become inverted about a year before every recession since 1950. You may also notice that there have been a few "false alarms" where the yield curve became inverted but no recession followed.

In the 1920s, the yield curve inverted in both 1923 and 1927, so its success rate as a recession predictor was only 50/50. From 1934-1950, the yield curve never inverted; it failed to predict 3 recessions (see graph below).

4) Is the Yield Curve "Smart"?
Why is the yield curve a useful tool in prediction recessions and equity returns?

One hypothesis is that bond investors are simply “smarter” than equity investors. Mom & Pop gamble on stocks in their retirement accounts, while bond trading is generally reserved for financial professionals. Perhaps bond investors can somewhat accurately predict recessions and their opinions are reflected in the bond market earlier than in the equity market.

Another possible explanation is that the shape of the yield curve directly impacts economic growth. For example, with a very steep yield curve, banks can easily produce great profits. They effectively “borrow” short-term via deposits and lend longer term via loans or buying treasuries. If the yield curve is steep they may be able to pay depositors 0.25% and then buy treasuries yielding 5% for easy profits. If the yield curve is inverted, it becomes extremely difficult for banks to make money.

A final and often ignored factor is that the shape of the yield curve is a reflection of recent actions of the Federal Reserve. Long-term interest rates tend to be anchored as investors correctly believe that interest rates revert to a common mean over many years. So, if the Federal Reserve reduces short-term interest rates, this is likely to produce a steeper yield curve; this effect is strengthened by the fact that lower short-term interest rates may increase long-term inflation expectations, which helps prevent the yield curve from falling in parallel. A steeper yield curve correlates to higher economic growth, but that may be a "confounding variable." Perhaps the growth is coming purely from the lower short-term interest rates, and the steeper yield curve is a byproduct. Similarly, a flat yield curve frequently occurs after the Federal Reserve raises short-term rates which has the effect of depressing growth. In other words, it may be the change in short-term interest rates that matters; the change in the yield curve is a byproduct of long-term interest rates moving less than short-term interest rates.

Each of the three explanations above is probably somewhat true and contributes to our empirical observation that the shape of the yield curve does a good job of predicting recessions.

5) Chinese Demand

A unique dynamic exists today that we must consider when extrapolating from the past. Our unprecedented trade imbalance with China makes them captive Treasury buyers. When Americans import more than we export, foreigners are left holding US dollars. Our greatest trade imbalance is with the Chinese who have been extremely risk averse with their dollar holdings. The Chinese government has maintained the trade imbalance by pegging their currency to ours to support their export sector. By pegging their currency, they’ve accumulated about $4 trillion US dollars. Some of that money is kept in simple currency, but they’ve used about $800 billion to buy treasuries. Maybe they’re thinking that a 2% yield, while small, is still better than nothing. Maybe they’re thinking that by lending us the money they are supporting the value of the total $4 trillion of US dollars they hold. Regardless, the Chinese policy decision to maintain the trade imbalance has the side effect of making them big Treasury buyers almost regardless of yield. They are rightfully concerned about the sustainability of our deficit though, so most of their Treasury holdings are short and medium-term. Under the "Preferred Habitat" lens, this means that the biggest marginal buyer of our treasuries does not want to hold our long-term debt. The result is that the price of our long-term debt drops relative to our short-term debt which means that the long-term yield rises; the yield curve steepens.

Economists who reject the "Preferred Habitat Theory" argue that the current yield curve means the market is predicting modest economic growth. While the yield curve throws doubt on the equity and commodity markets, it still appears more sanguine than many analysts. However, if the "Preferred Habitat Theory" is the dominant dynamic, the yield curve may not be a meaningful predictor today at all; without the large trade imbalance, perhaps the yield curve would be flatter today.

Your "Upward Sloping" Trader,

Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty, macroeconomics, security valuation, and how to think about markets and invest profitably -

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