Is the yield curve broken?

November 29, 2008 4:11 PM

MoneyFilter: Help me understand the Treasury yield curve.

According to Mutant and others, US Government Securities Yield Curve is an excellent predictor of the future of the U.S. economy. Specifically, an inverted yield curve (the rates on short term Treasury bills are higher than the rates on long term Treasuryy notes) is supposed to be very good at forecasting trouble ahead.

Right now, in the midst of all this turmoil in our economy, the spread between 3-month T-bills and 30-year notes is more than 3 percent, which some call a sign of economic health. But this defies common sense, because we're headed for a recession. Or are we?

Shouldn't the yield curve be flat or inverted now? Is something keeping short-term rates from rising (or their prices from falling)? What's happening here?

posted by up in the old hotel to work & money (4 comments total)

I think there is some cause/effect confusion; in general an inverted yield curve is bad as it is the fed "putting the brakes" on the economy. Now we have a cratering economy and a very aggressive fed trying get things going again.

Understand why the yield curve matters. In the simplest sense, banks borrow at the short term rate and lend at the long term rates, the spread is their profit. So when the curve is negative, banks will not lend, hence spending declines, and the economy with it. When the curve is very positive, the spread is enough to make lending very profitable and everyone gets a loan.

So no, the yield curve should not be flat/inverted. The govt is doing everything they can (monetary policy wise) to stimulate economy. One reason things are screwed up now is the bank looks at that 300bp spread now and says "not enough to cover default risk" and does not lend.

Whats keeping short term rates from rising is that we are looking at the prospect of serious deflation. The latest CPI showed an astonishing 12% annualized rate of deflation. At that rate (almost certainly not where we really are) a 0% nominal rate is a 12% real rate, thats outstanding return in bond-space.
posted by H. Roark at 5:07 PM on November 29, 2008

Specifically, an inverted yield curve (the rates on short term Treasury bills are higher than the rates on long term Treasuryy notes) is supposed to be very good at forecasting trouble ahead.

Oh, yes, the inverted yield curve is very good. It's predicted 7 of the last 2 recessions.

We are already in the recession. The yield curve was inverted through most of 2006 - everyone was talking about that. It flattened out in early 2007. The inverted yield curve is a leading indicator and it already predicted this mess we're in.
posted by ikkyu2 at 5:36 PM on November 29, 2008

There are two sides to this question: What affects the shape of the Treasury yield curve, and what aspects of the economy does the yield curve affect in turn? H. Roark has an excellent answer to the second one. Realize, however, that the term structure of interest rates is so fundamental to availability of capital (it is the price of money) and the feasibility of projects (it is the discount rate for valuing cash flows) that it influences pretty much all economic activity.

The first question has also generated PhD dissertations by the truckload, but when reading what others have said or are saying, it's helpful to remember two ways in which the present is different. First, the Fed has dialed the discount rate down to essentially zero---which it has never done before---and is therefore having no further influence on what the yield curve does. (Think of Japan in the 1990s.) Second, fear of deflation has created such strong demand for the safety of short-term Treasurys that they could pay negative interest and people would still buy them. In fact, for brief periods, this is actually happening.
posted by drdanger at 6:36 PM on November 29, 2008

Short term interest rates are set by central banks and are used to either stimulate or slow down economic growth. For example, in times of high inflation, a central bank will increase interest rates to slow down spending and in times like now, when the economy needs to be stimulated, central banks will decrease interest rates in the hope that this will help to increase spending. Taking this a step further, if interest rates are low now, that would normally indicate that there is more money available for spending (as people are more likely to borrow money at lower rates), which would therefore drive prices higher, causing inflation over time. If interest rates were high now, there would be fewer borrowers, which would lead to less spending, which long term would lead to stagnant or deflationary conditions.

Long term interest rates are market driven and though there are many theories on why a yield curve is shaped the way it is, generally it is a function of market forces and expectations of future inflation.

The reason that short term rates are not rising is, as H. Roark said, that the governement is doing everything they can to stimulate spending and the main way to do this is to lower interest rates.

The Yield Curve

Bond Yield Curve Holds Predictive Powers
posted by triggerfinger at 5:47 AM on November 30, 2008