I woke up this morning wanting to answer one question more than any other. Why is the yield on a 2-year bond (4.37%) higher than the 10-year yield of 4.35%? [1]

After some research, I have to admit I’m still a little lost. Understanding how our economy runs is not my strong suit (you’d be better off reading Chris’s posts). But I’ll take a stab at this.


Economists call what’s happening in the bond market an inverted yield curve2. The fact that we are seeing one now is cause for concern. From Investopedia:

Historically, inversions of the yield curve have preceded many of the U.S. recessions. Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle. A recent example is when the U.S. Treasury yield curve inverted in 2000 just before the U.S. equity markets collapsed. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are being demanded, sending the yields down.

That’s pretty scary stuff. If you’re looking for a reason to remain bullish, a Morning Star Bond Report3 had this to say:

Some economists continue to eye the yield curve as a daily economic indicator. Others question its utility, saying special factors, such as the government shifting issuance to shorter maturities, have distorted the curve’s telling powers.

So I’m not sure if I should be scared or not, but we still don’t know WHY the curve got inverted in the first place. The “why” in all of this would seem to be important. John Rutledge tries to sum things up this way (emphasis mine)4:

1. An inverted yield curve is not the end of the world. The last 4 recessions have all been preceded by inverted yield curves, but that does not mean that an inverted yield curve always implies a recession.
2. The important thing is why the yield curve is inverted. If the yield curve is inverted because the Fed has just forced a sharp increase in short rates (like 1980-81) you may have a problem. If it inverted because long rates have been easing lower to reflect moderating inflation worries (like today) it might be fine.
3. The anchor on inflation today is Chinese and Indian wage and prices. It makes sense for investors to expect low inflation in future years.
4. Either way, the condition is likely to be temporary because inflation is not likely to fall forever. It could be resolved next year by the Fed backing away from tightening short rates to keep bank reserves growing. Or it could be resolved by a major bankruptcy (GM? Ford?) which would push the Fed away from tightening.
5. Implication: in a world where the Fed is targeting prices, it is not appropriate to view them as an exogenous driver of the economy. Their behavior will adapt to outside influences on prices, e.g., oil prices, price and wage differentials, and technology changes.
6. The economy is growing, inflation is low, and profits are increasing at double digit rates. This is a great time to buy stocks. If people get spooked by the inverted yield curve and prices fall, buy more equities.

Ok, so our yield curve is inverted because long-term rates have been dropping (or in reality lagging behind short-term rates as the Fed hikes interest rates) “to reflect moderating inflation worries”. We’d only have to worry if the inversion was due to short-term rates increasing. Ahhhh.

I liked Katie Benner’s take over at CNN Money. Benner writes that a gradually flattening curve isn’t worrisome in itself, which is what we have now with the difference between 2-year and 10-year rates tightening by 10-15 basis points per month. Benner quotes Anthony Crescenzi who says, “It is when the pace becomes much faster than 15 basis points a month that investors should start to worry.” [5]

Hopefully this will help you understand what those folks on the TV are talking about. I’m interested in hear your thoughts.

References:
[1] Bloomberg Rates and Bonds.
[2] Investopedia Article on Inverted Yield Curves.
[3] BOND REPORT: Treasurys End Higher, Yield Curve Flattens After Data.
[4] Inverted Yield Curve by Dr. John Rutledge.
[5] Too fast, too soft… investor beware by Katie Benner.

Excellent article, Jason! Thanks for bringing this to our attention. Those of us just learning about bonds are sure to find this information useful.

For those who don’t know what a basis point is, 100 Basis Points = 1 Percentage Point. In other words, 1 basis point is .01%.

Also, take a look at Barry’s similar article from the finance blog, The Big Picture:
http://bigpicture.typepad.com/comments/2005/12/inverted_yield_.html

Barry is a chief market strategist at The Maxim Group, and cites WSJ frequently as he does in this article.

Great article!

This has been the discussion of many investors. However, in my discussions with my Wall Street counterparts (Fixed Income traders in particular), they have not be concerned by the inversion of the yield curve whatsoever.

The yield curve exhibits the expected return on a fixed income instrument (i.e. bonds) for the risk that an investor has to take on when purchasing the product. Typically, if you are surrendering your money for a longer period of time, it involves more risk and you would, therefore, expect a higher return. One of the underlying risks of investing in the long term is inflation expectations. If you are investing long-term, you might be worried that when it is time to cash out your bond 10 yrs from now, inflation could have outpaced your returns. This is why long-term instuments typically have higher yields.

However, when the economy is booming and the Fed is increasing rates agressively to control inflation (because that is their primary objective), investors are less concerned about inflation of the economy in the longer term. Hence, long-term rates begin to drop and inversion begins to occur when the market is speculative of the current (short-term) economic conditions. Investors, as we know, have been tip-toeing around the markets in fear of housing bubbles, deficits, and currency exchange rates.

Hope this helps! Cool stuff!
-Chris-

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Carnival of Investing #3

Welcome to Consumerism Commentary, this week’s host of the Carnival of Investing! The Carnival of Investing is a new Blog Carnival that collects the best blog entries in the past week or so that focus on the topic of investing. In the words of Mr…

[…] InvestorGeeks had a nice article on why the yield curve is inverted (meaning the yield on short-term bonds is higher than the yield on long-term bonds, for example the yield on the 2-year bond is 4.37% while the yield on the 10-year bond is 4.35%). Ok, so our yield curve is inverted because long-term rates have been dropping (or in reality lagging behind short-term rates as the Fed hikes interest rates) “to reflect moderating inflation worries”. We’d only have to worry if the inversion was due to short-term rates increasing […]

[…] the Baltic Dry Index. Read his analysis to determine why the author The fears the ancient mariner.The yield curve was inverted for some time lately. That is to say, the yield for the 2-year bond was higher than that of the […]