The Treasury Yield curve is very simply, a graph that plots the relationship between yields to maturity and time to maturity for a group of bonds. The slope of this curve, particularly as a tool of prediction of things to come has been an item of debate and discussion for many years if not decades among economists and policy makers alike.
The central concept of the “Time value of Money” suggests that as the time to maturity of the bond increases, the yield or the return on the bond should increase, as bond – holders or the lenders demand a greater premium for parting away with cash for a longer timeframe.
On taking a retrospective closer look at the yield curve, some very interesting patterns emerged:
YEAR - 2006 I’ve resorted to a random selection of dates for the study and have taken the yield curve for U.S. Treasuries. The yield curve began its inversion as early as Feb 2006, with the far end yields beginning to witness a dip. The steady progression of the inversion through the year has been captured in the following series of 5 charts:
Initially ( in Feb 2006 through June 2006 ) while the far end of the curve dipped , it still continued to offer a higher return than the short term bonds.
However, by August 2006 (see below) the far term maturity bonds fetched almost an equivalent return as that of the short end of the curve. Significant here was that the medium term (1 year to 6 years) witnessed a sharp drop in yields, suggesting that the Federal Reserve could be cutting interest rates in the medium term (which incidentally only occurs during an economic contraction)
What started off as a mild dip in far end yields in the beginning of 2006 evolved into a full- blown inversion by late 2006 , with the far end of the curve offering significantly lower yields that the shorter end .
While such a development might seem like an aberration of the Principle of Time value of Money, the understanding from a Demand-Supply perspective would probably prove more convincing. When yields drop, (in this case far term), it means demand for such maturity bonds outstrips the supply of bonds, indicating that investors preferred to jump into long term treasuries as they sensed a probable peak in long term interest rates.
On a retrospective reading of the yield curve, it can be seen that it amazingly presaged an economic recession and that interest rates would fall. Exactly, a little more than a year from the yield inversion, we saw the Dow Jones peaking at 14,100 on Oct 2009 (see chart below ) .The impact on the real economy was evident much later towards mid to late 2008 (see chart on US GDP and Employment)
Dow Jones Industrial Average
US ADVANCE GDP –QoQ
US Non Farm Payrolls -Employment created/lost
YEAR - 2009Pulling out the corresponding data for as recent as May 6th 2009, it can be seen that the Yield curve has once again moved into its normal curvature
What does it bode for the US economy?
In its broadest sense, a rising yield curve is reflective of markets expectation of interest rates increasing in the far end of the curve .This in itself could be foreshadowing any of the following:
An optimistic scenario of near term economic bounce or recovery as a result of the unprecedented liquidity infusion, which in-turn sparks (growth – led) inflation to edge up and interest rates to rise.
The case of cumulative deficits (trade, current and Budget account) reaching alarming proportions, whereby markets demand the US to pay up higher coupons (yields) to fund the bourgeoning deficits and keep alive the appetite for external financing of US deficits.
A hyper-inflationary scenario not caused by growth but by the fact that the dollar (in so much of excess supply) loses its value (a.k.a purchasing power) significantly – which in turn causes a sell off in US treasuries causing yields to rise – which is Markets way of saying “Give me more by way of current return to offset for the capital erosion ( weakening currency ) “
While the first case scenario would be the delight of every economic agent, the second and third possibilities appear more realistic given the massive expansion of the Fed’s balance sheet.
