The Yield Curve Is Telling Us Something

No matter how you measure it, after 12 straight Fed Funds rate increases over the last 19 months, the yield curve has been flattening. From June 30, 2004, when the Fed made its first raise in this long series of tightenings, the spread between 2-year and 10-year yields has shrunk from 1.9%, or 190 basis points, to under 10 basis points. Does the flattening of the yield curve hold any predictive power for investors? If so, what is it predicting?

First, a primer: The term structure of interest rates indicates the pattern of rates across a spectrum of maturities. This structure is typically represented as a yield curve which graphs the rates by maturity. The shape and slope of the yield curve is constantly changing, but typically it is upward sloping, with the interest rates on a longer-maturity bond higher than those for a shorter-maturity bond.

There are several reasons for this. There is the systematic risk that comes with general sensitivity to changes in interest rates. For example, longer maturity or duration securities will have greater risk and therefore greater expected return for bearing that risk. Everything else being equal, then, if this were the only factor determining the shape of the curve, then the more typical positively sloped curve would always exist.

There are other influences on the shape of the yield curve which may outweigh the systematic risk of interest rate sensitivity. For example, there is market segmentation among investors, where certain investors may need to buy or sell different duration securities. Pension funds may find it necessary to buy longer duration assets in order to better execute their asset/liability management. This may otherwise keep long-term rates lower. In 2003, mortgage investors such as Fannie Mae and Freddie Mac were influencing long-term rates as they sought to extend duration on their portfolios. This buying activity contributed to the rally in the 10-year to 3.07% in June 2003. Today, the appetite of foreign investors has contributed to lower long-term rates. Economists from the University of Virginia estimate that if foreigners had not accumulated any US bonds over the 12 months ended May 2005, the 10-year yield would be 150 basis points higher.

Another important determinant of interest rates and the shape of the yield curve is expectations for future inflation and the business cycle. Put simply, the expectations hypothesis says that long-term interest rates are averages of expected future short-term rates. A rise today in short-term interest rates may lead to a slowing of economic activity and thus a demand for credit in the future, which would put downward pressure on long term rates. Investors take into account this probability for economic activity and related inflation in making decisions because failing to do so can be costly, because of a potential loss of either value or interest income. For example, if an investor were to buy an investment grade 10-year bond paying interest at 5% per year, that may look like a wise decision based on today’s market rates. If inflation were to average 2% per year over that 10-year period, then real returns (i.e., adjusted for inflation) would average 3%. However, if inflation were to average 6% per year, then real returns would average -1%. Thus, if an investor believes that inflation will be higher going forward, he or she will demand a higher nominal rate of interest and vice versa. The low inflationary (even deflationary) expectations of 2003 was one of the causes of low nominal rates, while the much higher inflationary expectations of the late 1970s was the primary cause for high nominal rates during that period. As inflationary expectations change, prices for bonds go up or down, affecting returns.

According to research conducted by the Federal Reserve Bank of St. Louis, typically long rates change 30 bp for every 100 bp change in short rates. That hasn’t happened during this tightening cycle. Market observers, including Alan Greenspan, have wondered why this is so. Given the size and duration of the tightening regimen, there should be more of an inflationary expectation built into the longer end of the yield curve as the Fed has clearly maintained that inflation is a worry. William Poole, president of the Federal Reserve Bank of St. Louis, asked the same question in a speech he delivered in June: “A topic much discussed in recent months is the relationship over the past year or so between long-term and short-term interest rates. Some observers have argued that the failure of long rates to trend up as the Fed has increased its target federal funds rate is a puzzle. Others have argued that Fed policy is ineffective because increasing the short rate is not affecting the long rate.” He attempted to answer this puzzle by arguing that because expectations for economic activity and Fed monetary policy have turned out essentially the way the market expected, there was no reason for rates to change. As he explained: “Think of the issue this way. At the beginning of a planning period the Fed has in mind a probable course for the economy and expectations about the policy adjustments that will be consistent with long-run policy objectives. Suppose the market has the same understanding as the Fed. Suppose also that events turn out largely as expected. Then, everything goes according to plan, including policy adjustments and the course of bond rates.”

That’s a fairly convenient explanation, as it presumes not only omniscience—that the Fed knew how the economy would behave once it began its tightening policy—but it also suggests that the Fed had planned from the outset exactly how many tightenings it was going to need to make before it was done. On top of all that, his explanation requires the market to be so synchronized with the Fed in this policy process that it was already discounting the ultimate outcome: The Fed would be successful in preserving price stability and therefore no change in bond rates was necessary.

Whatever the reason for the seeming intractability of long-term rates—for what its worth, we come down on the market segmentation argument to explain why the long end of the yield curve has been so stubborn during this tightening process—the fact remains that the curve is flat, almost inverted. Past yield curve flattenings and inversions have come about from sharp increases in short term rates. Moreover, yield curve steepenings typically occur as a result of decreases in short term rates. The graph below illustrates this relationship in the 1-year Treasury rate and the 10-year Treasury rate going back to 1962.

Note on the graph above that we have indicated recessionary periods in the US by the yellow bars. Arturo Estrella, an economist with the Federal Reserve Bank of New York, observed in a recent paper that every recession since 1950 has been preceded by a yield curve inversion between the 3-month T-bill and the 10-year Treasury note. In “The Yield Curve as Leading Indicator: Frequently Asked Questions” (October 2005), Estrella says, “The difference between long-term and short-term interest rates has borne a consistent negative relationship with subsequent real economic activity in the United States, with a lead time of about four to six quarters.” The Conference Board, which calculates the US Leading Economic Indicators Index, includes in its set of indicators the interest rate spread between 10-year Treasuries and Fed Funds because “when it becomes negative its record as an indicator of recessions is particularly strong.” With the 10-year Treasury yield currently under 4.5%, the curve will likely invert with two more tightenings (all else being equal).

The predictive power of the shape of the yield curve is important to investors because it also becomes a predictor of future monetary policy. As Estrella explains:

“Although there are different views of the instruments and channels of monetary policy, a tightening of monetary policy usually means a rise in short-term interest rates, typically intended in the end to lead to a reduction in inflationary pressures. When those pressures subside, it is expected that a policy easing will follow. Expected future short-term rates are important determinants of current long-term rates. Thus, long rates tend to respond to a monetary tightening by increasing, though given that a policy reversal is expected, they tend not to increase by as much as short-term rates. Thus, a simple explanation of the predictive power of the yield curve for future output growth is that a monetary tightening both slows down the economy and flattens (or even inverts) the yield curve. Monetary policy is therefore an important determinant of the predictive power of the yield curve.”

The conclusion we draw is that the shape of the yield curve can’t tell us when the Fed will stop, but that it does give clues about what to expect once it is done. First, if indeed the curve inverts, then it is reasonable to expect that an economic slowdown if not a recession is in the offing. Second, if the Fed gets to the end of its tightening regime and slows down the economy, then at some future point it will have to reverse the course of monetary policy. The market will typically try to lead the Fed by factoring in future expectations, and the tracks of this are evident in the yield trends in the two-year Treasury, the maturity on the Treasury yield curve that is most sensitive to Fed policy moves. The graph below demonstrates how in each of the last three tightenings, in 1994-95, 1999-00 and today, the two-year anticipated the Fed on the way up, and that it also anticipated the subsequent easing part of the cycle, too. Note that there is typically a lot of volatility around the turn in sentiment, and that the Fed Funds/2-year spread can invert significantly.

The current dance between the market and the Fed is playing out with the two-year seeming to have called a top of around 4.5% (see graph below). It remains to be seen if the market will be right. However, the minutes of the November 1 FOMC meeting, released on November 22, revealed that certain members of the Fed have initiated the debate on when and how to stop. “[P]olicy setting,” the minutes read, “would need to be increasingly sensitive to incoming economic data. Some members cautioned that risks of going too far with the tightening process could also eventually emerge.”

In sum, the yield curve, which is flattening and nearing inversion, is reminding us that monetary policy runs in cycles that go from steep to inverted and back again, typically led by Fed policy actions. It is revealing to us that as it nears inversion, the economy is at greater risk of falling into a recession over the next year or so. It is thus suggesting that the Fed may be nearing the end of its tightening cycle. Certainly the Fed Funds futures market is handicapping an end, likely somewhere around 4.75%. As the markets and the Fed digest more economic data, the likelihood of the end point will come into clearer focus, particularly if the data support a weakening economy and contained inflation.

Of course, it could be different this time. The predictive ability of the yield curve may be clouded by the influence of market segmentation—the demand for duration by pension funds or the insatiability of foreign investor appetite for US financial assets. The risk of inflation from a secular increase in oil prices could be judged too potent, prompting the Fed to continue its tightening beyond where it would normally be expected to stop. The economy, particularly in the rebuilding wake of Hurricanes Katrina and Rita, may have enough strength to continue to hum along even as the Fed Funds rate rises. Perhaps the incoming Fed chairman, Ben Bernanke, would have an agenda that has personal inflation-fighting credibility above the best interest of the economy. In any event, an inverted yield curve is telling us something. We’ll know more in the course of the next several months exactly what it is.

November 29, 2005
Jeremy Diamond
Executive Vice President
Annaly Capital Management/FIDAC

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