Inverted Bond Yield Curve

[albionmoonlight]

So I get that it means that the short term bond rates are higher than the long term rates.

And I get that this may preceed a recession.

But that is all that I got from the article that I read this morning.

Can anyone with knowledge of these things help explain what is going on and what it means? Thanks.

[Farrah Whitworth-Rahn]

Not sure what you read this morning, but this article (http://online.wsj.com/article/SB113569973698732182.html?mod=economy_lead_story_lsc) from the WSJ (subscription required for link) explained a lot.

I'm far from an expert here - very far. But from what I understand, this can be a precursor to a recession because banks tighten up their lending requirements. Usually by limiting the supply of loans, and raising their interest rates. Since many think the economy as of late has been driven by the free flowing home equity loans and LOC's, a recession makes sense. Higher interest rates on adjustable rate LOC's and mortgages, less cash to spend on other things. First thing that goes is discretionary spending.


Yields on Bonds Invert, Reflecting
Unease About Economy's Future
By MARK WHITEHOUSE
Staff Reporter of THE WALL STREET JOURNAL
December 28, 2005; Page A1

The nation's bond market interrupted the holiday season with a downbeat message yesterday: Many investors expect the economy to hit tougher times within the next year or so.

That pronouncement came in the form of long-term interest rates dropping below short-term rates, a trend that often -- but not always -- precedes an economic downturn. The development is known as an inversion, because it flips the traditionally upward-sloping shape of bond yields plotted on a graph. The yield curve typically rises because longer-term debt usually pays higher interest rates to compensate investors for the greater risk they incur waiting for repayment.

Inversions can squeeze or even eliminate profit margins for banks, hedge funds and any other financial business that borrows money at short-term rates and lends it at long-term rates. "This is a warning signal...that we are on recession watch now," says Paul Kasriel, chief economist at Northern Trust Co. in Chicago. The inversion, however, so far is minor, he says. And some economists believe an inversion isn't as reliable a predictor as it once was.

In late New York trading, the yield on the 10-year Treasury note, which reflects investors' long-term view of the economy and is a key benchmark for mortgage loans, had dropped just slightly below the yield on the two-year note, which tracks expectations for the Federal Reserve's monetary policy in the nearer term. The 10-year note's price was up ¼ point, or $2.50 for each $1,000 in face value, to yield 4.343%. The two-year note was up 1/32 point to yield 4.347%, and the 30-year bond was up 21/32 to yield 4.508%.

<reprintsdisclaimer></reprintsdisclaimer>The bond market's gloom may seem incongruous, given that inflation remains under control and the economy grew at an annual rate of 4.1% in the third quarter, marking the eighth straight quarter of one of the most stable stretches of growth on record. Analysts cautioned against reading too much into the timing of the inversion, which came amid a dearth of economic or other market-moving news and amid thin holiday dealings. Still, it was the first inversion in five years, and many see it as a signal of bigger, sustained moves to come. It was also cited as a factor behind a weaker stock market yesterday. (See related article (http://online.wsj.com/article/SB113568525985832051.html?mod=article-outset-box)⁵.)

"The big question is how dramatic [the inversion] becomes," says Thomas Girard, co-head of fixed income at Weiss Peck & Greer Investments in New York.

Bonds make fixed interest and principal payments to investors, but their yield depends on what the market is willing to pay for the bonds on any given day. In deciding what yield -- or return -- to demand on bonds, investors consider various factors, including their expectations for future short-term interest rates and the bond's duration.

Investors, for example, usually demand more yield from governments and companies to tie up their money in longer-term bonds. When they are willing to accept a lower yield, that means they are persuaded that the Fed, which most expect to raise short-term rates to 4.5% or higher early next year, will soon have to bring those rates back down to mitigate, or ward off, a recession. Yield-curve inversions have preceded all of the last six recessions, but have also sounded two false alarms, the most recent in 1998.

The housing market is the most likely trigger for an economic slowdown and Fed reversal. As the Fed raises rates, monthly payments on adjustable-rate home loans go up, cooling demand for houses and leaving homeowners with less money to spend on all the other things companies want to sell them. Second, as house prices stall, homeowners aren't able to borrow as much against the value of their homes -- a source of cash that has added hundreds of billions of dollars to consumers' spending power in recent years.

http://online.wsj.com/public/resources/images/P1-AD929A_crdle_20051227200412.gif "What the Fed is going to do is shut down the ATM machine known as the housing market," says Tad Rivelle, chief investment officer at Metropolitan West Asset Management in Los Angeles. Fed policy makers hold their next meeting on Jan. 31, which is expected to be the last before Chairman Alan Greenspan retires, leaving the reins to Ben Bernanke, the nominee to succeed him.

The Fed's attempts to cool the economy, however, don't always provoke a recession, and many economists, including Mr. Greenspan, suggest that the yield curve might have lost its predictive abilities. That's because foreign buying of U.S. Treasurys and the Fed's success in controlling inflation have kept long-term interest rates unusually low, so U.S. consumers and companies still have relatively cheap access to money that they can spend on buying houses and building factories.

A recent study published by the Fed estimated that in the absence of foreign buying, the difference between two-year and 10-year yields would be about 0.75 percentage point greater.

"Many factors can affect the slope of the yield curve, and these factors do not all have the same implications for future output growth," Mr. Greenspan wrote in a recent letter to Congress.

But even if it doesn't presage recession, a severe and prolonged inversion can cause a lot of pain, particularly for banks and hedge funds that make long-term investments with money borrowed at short-term rates -- the so-called carry trade. Big banks such as Citigroup Inc.'s Citibank unit and J.P. Morgan Chase & Co. have already cited the flattening yield curve as a factor affecting profits, as the interest rate they must pay to attract deposits rises closer to the return they can expect on their investments. "You can't make it up on volume if you're borrowing at 4.25% and lending at 4%," Northern Trust's Mr. Kasriel says.

Write to Mark Whitehouse at [email protected]⁶

<!-- article end --> <table border="0" cellpadding="0" cellspacing="0" width="477"><tbody><tr> <td style="line-height: 1px; width: 70px;" width="70"> </td> <td style="font-family: Arial,Helv,Helvetica; font-size: 11px; font-weight: bold;" width="407"> URL for this article:
http://online.wsj.com/article/SB113569973698732182.html

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(3) http://online.wsj.com/article/SB113528182051629707.html
(4) http://online.wsj.com/article/SB113331001503709619.html
(5) http://online.wsj.com/article/SB113568525985832051.html
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[Farrah Whitworth-Rahn]

Dola - couple the yield curve with provisions of the 2001 tax cuts expiring, uncertainty as to Bernanke and what a Fed under him will do, energy costs, etc. some folks are saying recesssion is near.

EDIT to add - and yesterday's sell off is getting a fair bit of attention this morning. IMHO, part of that is related to the yield curve, and some of it is related to the usual end of year sell off. Investors rebalance their portfolios this time of year, it's not uncommon for the DOW to dip close to the end of the year.

[George]

From eveything I've read, there doesn't appear to be much danger of a recession. The economy is pretty solid, and the inversion didn't happen overnight. Also, the curve is more flat than anything. There seems to be a lot of money floating around the world looking for a place to settle.

In any case, an inverted yield curve is not a good thing. :eek:

[George]

Dola-

This is not to say a recession can't happen. Best advice? Stay tuned.

[albionmoonlight]

Thanks for the info. The article I read was in the local paper and not nearly as detailed as the one you posted.

[George]

Here's another article on it.

http://news.yahoo.com/news?tmpl=story&u=/nm/20051227/bs_nm/markets_inversion_dc_1

[I. J. Reilly]

Of course it can be argued that this is a sign of strength for the U.S. economy. All of those foreign countries that are running huge trade surpluses (China) need to stash money somewhere. When they survey the world for a safe haven America is far and away their number one choice, the 10 year Treasury being the favorite. All of that buying pressure naturally drives yields down. There is no demand from these buyers for the shorter-term offerings, so the yield curves begin to move independently. Thus, the theory goes, the inversion means little because two separate forces are driving each interest rate. It does not mean that investors see the economy as being worse in the future then it is now, which is the traditional meaning of an inverted curve.
Of course the most dangerous words ever uttered on Wall Street are “it’s different this time.”

[sterlingice]

Interesting thread. Learn something new on FOFC every day :D

SI

[JeeberD]

Not sure what you read this morning, but this article (http://online.wsj.com/article/SB113569973698732182.html?mod=economy_lead_story_lsc) from the WSJ (subscription required for link) explained a lot.

I'm far from an expert here - very far. But from what I understand, this can be a precursor to a recession because banks tighten up their lending requirements. Usually by limiting the supply of loans, and raising their interest rates. Since many think the economy as of late has been driven by the free flowing home equity loans and LOC's, a recession makes sense. Higher interest rates on adjustable rate LOC's and mortgages, less cash to spend on other things. First thing that goes is discretionary spending.

It turns me on when you talk economics, baby...

[SFL Cat]

hmmm, based on the title, I thought this thread might be about a new kind of sex position. ;)

[cthomer5000]

Is anyone personally aware of a good investment discussion board?

[Logan]

I suggest people go to www.bancinvestment.com (that's the way they spell "bank"...not a typo). This group publishes a daily newsletter, appropriately called Banc Investment Daily, that discusses major economic developments, Federal Reserve meetings, bank news, mergers, etc. It will discuss upcoming rate hikes and explain ramifications. They talk about the inverted yield curve and what it will mean, and how it will affect banks, frequently.

I'm subscribed to it because I work in bank regulation, but I believe anyone can sign up for a free email subscription (and if not, just say you're a regulator :)).

[QuikSand]

There is also a school of thought that there is a fundamental rethinking of long-term borrowing going on right now -- and that this, in part, helps explain the seeming disconnect between short term and longer term interest rates.

We've seen this in the housing market for some time now -- as the Fed has steadily increased rates, there has been little or no effect on prevailing mortgage rates, even after a fair amount of time to adjust. It's been very odd... but interest rates are really a function of attitudes, and some economists are starting to think that there's a new paradigm at work here, rather than just another leg in a predictable cycle toward recession.


Thanks for the WSJ link, Farrah - good explanation of these issues.

[albionmoonlight]

There is also a school of thought that there is a fundamental rethinking of long-term borrowing going on right now -- and that this, in part, helps explain the seeming disconnect between short term and longer term interest rates.

We've seen this in the housing market for some time now -- as the Fed has steadily increased rates, there has been little or no effect on prevailing mortgage rates, even after a fair amount of time to adjust. It's been very odd... but interest rates are really a function of attitudes, and some economists are starting to think that there's a new paradigm at work here, rather than just another leg in a predictable cycle toward recession.


Thanks for the WSJ link, Farrah - good explanation of these issues.
Do they have an idea of what the new paradigm is?

[Farrah Whitworth-Rahn]

There is also a school of thought that there is a fundamental rethinking of long-term borrowing going on right now -- and that this, in part, helps explain the seeming disconnect between short term and longer term interest rates.

We've seen this in the housing market for some time now -- as the Fed has steadily increased rates, there has been little or no effect on prevailing mortgage rates, even after a fair amount of time to adjust. It's been very odd... but interest rates are really a function of attitudes, and some economists are starting to think that there's a new paradigm at work here, rather than just another leg in a predictable cycle toward recession.


Thanks for the WSJ link, Farrah - good explanation of these issues.Is it the investment community re-thinking how it factors borrowing into their analysis? Or the banks themselves?

I ask because the banks out here seem to be giving money away. One of the Wells Fargo branches was offering a 103% mortgage a few months ago, and people I know can't afford homes are able to get financing at pretty decent rates. It seems too easy to get financing for a house. I don't remember it always being this way.

[George]

There are so many factors at play, it's tough to pin down exactly what is happening. Globalization is definitely having an impact. The large amount of money chasing returns is another, albeit that's related to globalization. Also, the market seems to be saying that it doesn't see inflation being an issue in the long run. That, along with significant increases in productivity, is likely a big part of why long-term rates have remained low.

[Farrah Whitworth-Rahn]

From today's WSJ (http://online.wsj.com/article/SB113578440504233033.html?mod=economy_lead_story_lsc) (subscription required for link).


Economists Ask
If Bonds Have Lost
Predictive Power
By MARK WHITEHOUSE
Staff Reporter of THE WALL STREET JOURNAL
December 29, 2005; Page C1

Now that the bond market is behaving as if the economy is in trouble, investors who would like to believe otherwise need ask themselves: Is past prologue?

When yields on longer-term U.S. Treasurys fell below those of short-term securities Tuesday, they traced a pattern that often has been seen shortly before the economy trended lower or even tanked.

http://online.wsj.com/public/resources/images/OA-AB981_YieldC_20051228163622.gif But amid overall low interest rates and one of the most stable stretches of economic growth in U.S. history, many economists are saying the bond market must be wrong this time.

"I think the bond market is on drugs," says Ethan Harris, chief U.S. economist at Lehman Brothers in New York. "It's hard to take the yield curve seriously as a recession indicator." Even Federal Reserve Chairman Alan Greenspan has argued that the yield curve may have lost its oracle status.

Economic optimists also note that the "yield curve inversion" -- so called because it reverses the normal upward slope of bond yields, from short to longer term -- isn't yet severe. Indeed, in late New York trading yesterday, the difference in yield between two- and 10-year Treasury notes -- a popular measure of the curve -- had eked back into traditional territory. The two-year note's price was down 2/32 to yield 4.373%, while the 10-year was off 9/32, or $2.81 for each $1,000 in face value, to yield 4.376%. In other words, that snapshot of the yield curve was pointing ever so slightly upward again.

<reprintsdisclaimer></reprintsdisclaimer>Most market professionals, however, expect the inversion to return and deepen. And history has been brutal to economic forecasters who have doubted the yield curve's predictive powers. Over the past 50 years, the yield curve has given only two false signals, and the most recent head fake may have been caused by some very big extenuating circumstances: In 1998, investors spooked by a financial crisis in Russia and the demise of investment firm Long-Term Capital Management fled to the safe harbor of Treasury bonds. That pushed up the prices of those securities, and therefore drove down their yields, so low that long-term yields fell below shorter-term rates. But the economy survived, and even the swooning stock market righted itself.

When the curve last headed toward inversion in early 2000, with the yield on 30-year bonds falling below the yield on 10-year Treasurys, most of the major Wall Street banks saw little reason for concern.

Their rationale: The government, which was running a budget surplus at the time, was selling fewer long-term bonds, creating a shortage of those securities that pushed their prices up and their yields down.

For a bit of deja vu, consider a February 2000 report from Deutsche Bank: "When this spread went negative in the past, it either foreshadowed a recession or a sharp slowdown in growth in the immediate quarters ahead. Fortunately for Main Street, we do not think the 10s/30s inversion is sending us that message."

Four quarters later, however, the economy did indeed slip into recession.

This time, economists have some more weighty arguments against the voice of the yield curve. Chief among them is that long-term rates have remained extremely low for a variety of reasons unrelated to recession fears.

For one, foreign investors have piled into U.S. bonds.

http://online.wsj.com/public/resources/images/OA-AB977_WSJCOM_20051228161545.gif Second, as the U.S. population ages and companies or the government try to fund traditional pension plans, demand has grown for the kind of long-term bonds that can guarantee payments to future retirees.

Third, the Fed's success in controlling inflation over the past couple decades has led investors to demand less compensation for future inflation. All these factors have brought down long-term yields.

A recent report published by the Fed estimates that foreign buying alone has depressed the 10-year yield, which forms the basis for yields on corporate and mortgage bonds, by as much as 1.5 percentage points.

That means that consumers and companies can still borrow money cheaply.

Even the Fed's steady increases in its short-term interest-rate target over the past year and a half haven't brought it to a level that, by historical standards, would be considered a brake on the economy.

The rate now stands at 4.25%. However, dealings in the futures market suggest it will rise as high as 4.75% -- about 2.75% in real terms, or after inflation.

The average real Fed funds rate during the past nine yield-curve inversions was a much more restrictive 4.88%. Interestingly, the real rate was particularly low -- 2.74% and 3.68%, respectively -- during the inversions of 1966 and 1998, the last two times the yield curve gave false alarms.

That said, even today's interest rates could have more of an effect on the economy than they would have in the past, because U.S. consumers -- the engine of global growth -- are more indebted than ever.

Total household mortgage debt alone stood at $8.2 trillion in September, compared with $4.8 trillion before the last recession in 2000. As much as 45% of that mortgage debt is floating-rate, meaning that monthly payments rise when the Fed increases short-term rates, though often with a lag.

As the cost of mortgages goes up and cuts into demand for houses, consumers are hit with a double-whammy: They must make higher payments to stay current on their mortgages, and they can no longer supplement their spending power by borrowing against rising home values. A housing slowdown alone would hack away a big chunk of economic potential.

Write to Mark Whitehouse at [email protected]⁶

<!-- article end --> <table border="0" cellpadding="0" cellspacing="0" width="477"><tbody><tr> <td style="line-height: 1px; width: 70px;" width="70"> </td> <td style="font-family: Arial,Helv,Helvetica; font-size: 11px; font-weight: bold;" width="407"> URL for this article:
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(1) http://online.wsj.com/article/SB113569973698732182.html
(2) http://online.wsj.com/article/SB113528182051629707.html
(3) http://online.wsj.com/article/SB113331001503709619.html
(4) http://online.wsj.com/public/page/0,,8_0000-ZY1Jpf8RnvaP8dxJ65QjpouwR|P6Gqew-ArmRJocWOdASGA54WZDWnk8kmKu57v|L,00.html?mod=ARTICLE_VIDEO (http://online.wsj.com/public/page/0,,8_0000-ZY1Jpf8RnvaP8dxJ65QjpouwR%7CP6Gqew-ArmRJocWOdASGA54WZDWnk8kmKu57v%7CL,00.html?mod=ARTICLE_VIDEO)
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(6) mailto:[email protected] ([email protected])</td></tr></tbody></table>

[George]

Another good article. :cool:

[QuikSand]

Third, the Fed's success in controlling inflation over the past couple decades has led investors to demand less compensation for future inflation. All these factors have brought down long-term yields.

This, potentially, is the underlying paradigm shift that some believe is taking hold. If people no longer really are factoring in meaningful inflation into their long term thinking, then their requirement for a premium in longer term lending may be gone (at least for now).

[Logan]

Is it the investment community re-thinking how it factors borrowing into their analysis? Or the banks themselves?

I ask because the banks out here seem to be giving money away. One of the Wells Fargo branches was offering a 103% mortgage a few months ago, and people I know can't afford homes are able to get financing at pretty decent rates. It seems too easy to get financing for a house. I don't remember it always being this way.

Banks with good management have been realizing that the real estate market is going to begin to weaken, and have started planning accordingly. But some banks are still okay with qualifying people for loans for homes that they can't afford, because after all, they had just sold their house that had a $180,000 loan for $300,000, so why would they be a credit risk for a $500,000 loan? Meanwhile, the bank will rake in the fee income that comes with it, while bundling that loan with other mortgages and selling them on the market.

Bottom line is we're gonna soon be seeing a lot of bank's loan portfolios get crushed due to underwriting weaknesses.

[Crapshoot]

Of course it can be argued that this is a sign of strength for the U.S. economy. All of those foreign countries that are running huge trade surpluses (China) need to stash money somewhere. When they survey the world for a safe haven America is far and away their number one choice, the 10 year Treasury being the favorite. All of that buying pressure naturally drives yields down. There is no demand from these buyers for the shorter-term offerings, so the yield curves begin to move independently. Thus, the theory goes, the inversion means little because two separate forces are driving each interest rate. It does not mean that investors see the economy as being worse in the future then it is now, which is the traditional meaning of an inverted curve.
Of course the most dangerous words ever uttered on Wall Street are “it’s different this time.”

That last line should be bolded and shown to everyone - good explanation. I admit my personal belief is that Asian treasury buys are a significant factor in the relative flattening of the yield curve.