Risk over Reward

A Weekly Newsletter about Investing

The Yield Curve

by Alpha and Vega, an Investor and a Trader
December 13th, 2009

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.

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and uncertainty, macroeconomics, security valuation, and how to think about markets and
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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,

Vega
vega@riskoverreward.com

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