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Ignoring the Yield Curve May Be Dangerous to Your Health

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Ignoring the Yield Curve May Be Dangerous to Your Health

January 21, 2015

Economists clearly have too much time on their hands. "Fed watcher" is no longer part of the job description now that the Federal Reserve provides guidance on what it plans to do. A reliance on econometric models has taken some of the thought process out of forecasting. And blogging has supplanted the need for real-time economic analysis.

So what's an economist to do? Why, deconstruct long-term Treasury yields, an academic exercise if there ever was one. In the past few weeks, economists have tried to assure us that the decline in long-term Treasury yields - more than 100 basis points on the 10-year note in the past year - is nothing to worry about. While a robust economy is typically associated with rising long-term interest rates, lower yields this time around are the result of a decline in inflation expectations and the "term premium," not in the real rate of interest. 

Before you roll your eyes and click the back arrow on your browser, a quick primer. The nominal yield on long-term Treasuries is composed of expectations for the real short-term interest rate over the life of the bond, inflation expectations and a term premium: the additional compensation investors require for assuming additional risk. It should be noted that none of these components can be observed directly. (Who needs observation when you have a model?)

Most forecasters had been expecting 2015 to be a banner year for the U.S. economy, which ended 2014 on a strong note. Real GDP growth averaged 4.8 percent in the second and third quarters, the fastest two-quarter pace since 2003. And the economy probably expanded at a 3 percent pace in the fourth quarter, according to estimates.

The current readings on the economy - from the labor market to business and consumer confidence to manufacturing - all look pretty good. The dollar is strong. The U.S. stock market set an all-time high less than one month ago. Crude oil prices have tumbled 57 percent since June. Economists tell us this will give consumer spending a big boost. (Falling prices are less of a "gift" if they are a reflection of weak demand, not a function of over-supply.)

But those falling bond yields, compounded by a dive in commodity prices, keep nagging at economists, and for good reason. The yield on the 30-year Treasury bond hit an all-time low of 2.35 percent last week. Does the market know something forecasters don't?

Confronted by warning signals, economists are latching on to a statistical model from the New York Fed that decomposes long-term interest rates. The model shows that the real interest rate - the rate that reflects long-term growth prospects and potential returns - has actually risen in the past year and is no longer negative. Ergo, no need to worry. Everything is cool.

Maybe you can tell where this is going. The yield curve is still historically steep, but I have already seen research claiming that were it to invert as the Fed raises rates over the next couple of years and the term premium shrinks, it would not mean the same thing it always has: a harbinger of recession. 

In other words, this time is different. (It's always different until it's not.) It was different when the curve inverted in mid-2006. Economists, including then-Fed chairman Ben Bernanke, argued that a "savings glut" was depressing long-term rates. This time around, should it happen, it will be the term premium that invalidates the message. (Alan Greenspan actually invoked the term premium to explain the "conundrum" of low long-term rates during the 2004-2006 tightening cycle.)

Let's face it: The spread may be too simple for PhDs to understand. And the beauty lies in its simplicity. The difference between a Fed-pegged overnight rate and a market-determined long-term rate can be observed at any time; it is never revised; and it is free. Why it does what it does really doesn't matter. The wider the spread, the greater the incentive for banks to increase their earning assets (make loans or buy bonds). That leads to an increase in the money supply and aggregate demand. The reverse is true for a flat or inverted yield curve.

At times when the banking system is impaired, it takes a wider spread for a longer period of time to achieve the same result. That was the case in the early 1990s, following the Savings and Loan crisis, and it was the case in the current expansion with its necessary deleveraging. 

There is no lack of reasons to explain the collapsing term premium, according to economist Neal Soss, Vice Chairman of Credit Suisse. Given the depressed yields on sovereign debt of other developed nations, foreign demand for Treasuries should stay strong. An increase in life expectancy is driving a need for longer-term assets. Finally, the Fed owns $2.5 trillion of longer-term Treasuries and has no immediate plan to sell them.

Identifying the term premium may be an interesting statistical exercise, but I fail to see the practical application as it pertains to the yield curve. It is the shape of the curve that matters. Its track record, should it invert for whatever reason, in forecasting recessions is impeccable. Bending the curve to fit the forecast has never been a fruitful exercise. I doubt it will yield benefits in the future.

 

Caroline Baum is a contributor to e21. You can follow her on Twitter here.

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