"Flattening yield curve argues against higher interest rates"

[Mr._Graybeard]

I ran across this article in The Economist yesterday and thought it had some good food for thought. Not that interest rates aren't on an upward trend, just pointing out one of the headwinds out there.


https://www.economist.com/news/finance-and-economics/21731850-difference-between-short-and-long-term-yields-its-lowest-decade

 

[Lsbcal]

I watch the spreads between the 10 year Treasury and the 3 month. But understanding the mechanisms behind the gyrations is tough and not rewarding to me. It would be great to see a simple math model.

Thanks for the link.

 

[FIRE'd@51]

It would be great to see a simple math model.

It is a function of the forward rate. Let

R5 = 5-yr rate
R10 = 10-yr rate
F= forward 5-yr rate (5-yr rate 5 years from today)

To avoid riskless arbitrage

(1 + R5)(1 + F) = (1 + R10)^2

Solve for F

F = (1 + R10)^2 / (1 + R5) - 1

Example:

R5 = 2.10%
R10 = 2.35%

F = (1.0235)^2 / (1.021) - 1 = 2.60%

Assume R10 drops to 2.25% and R5 remains the same (yield curve flattens)

F = (1.0225)^2 / (1.021) -1 = 2.40%

Flattening yield curve implies lower 5-yr rate 5 years from today

 

[audreyh1]

You can see the flattening in action on this page which shows the current yield curve versus one year ago in the YIELD CURVE - US graph. Right now the crossover is at the 10yr Treasury mark. Lower duration treasuries have higher rates, but higher duration treasury rates have dropped over the year.
https://www.marketwatch.com/investing/bond/tmubmusd10y?countrycode=bx

 

[audreyh1]

A regular poster on Morningstar occasionally updates a “Market-based Forward Rates” post which includes the 5 year treasury rate 5 years forward. As of Nov 4 it was 2.67% which is about 50 basis points above where we are now, indicating a very modest rise in intermediate rates on average over the next five years.

Here is his Nov 4 post:

Here's what's built into prices and curves at Friday's close:

Fed funds: next hike December to 1.38%. After that Q3-2018 to 1.63%. December 2019 to 1.88%. December 2021 to 2.125%. Mar 2024 to 2.38%.

5yr Treasury rate 5 years forward Q4-2022 = 2.67%

Inflation TIPS/Treasurys:

5yrs: 1.85% 10yrs: 1.87% 30yrs: 1.93%

Many observers and talking heads note the dissonance between higher Fed dot-plots versus the Fed funds and LIBOR futures markets. Just talking with a few folks on the issue, I was surprised to hear the characterization of reasons for the difference :

1. Fed is unable to hike rates because political turmoil in DC (investigations, trials, bizarre behavior, movement toward war) affects domestic and global institutional investors.

2. An easy-to-anticipate serious economic slowdown or recession in the 2018-2020 timeframe.

As always, its important to remember that nobody at all might think these curves provide an accurate picture of future events. The Fed funds shorts in the open interest believe rates will be higher -- and the longs believe they need protection from rates being lower.

Regards, Dick

I’ll post the Dec update when he makes it available.

 

[Mr._Graybeard]

This AP story caught my eye, since I hold some municipal bonds. Muni bond Friday update: 10-year yield decreases

It puts the 4-year-yield at 1.7%, with the 2-year/10-year spread at just 87 basis points. The 2-year/30-year spread is just 137 basis points, down 6 bp from a week ago.

Who would tie their money up 30 years for less than a point and a half? The demand can't be too high ... but then, perhaps the supply of bonds isn't that high either.

Here's another slightly off-topic observation, but still related to inflation and interest rates. The amount of cash money in the US economy has traditionally been dwarfed by the amount of borrowed money in the economy, known as the credit multiplier. But that credit multiplier has been less than the money supply since the end of the 2008-'09 recession. https://fred.stlouisfed.org/series/MULT

Until that credit multiplier gets moving, the market is going to keep longer interest rates low. The Fed can tinker with the short-term numbers, but the long rates reflect the true state of the economy and ultimately (IMO) will limit the Fed's ability to boost interest rates. That's what the flattening yield curve reflects.

 

[audreyh1]

Until that credit multiplier gets moving, the market is going to keep longer interest rates low. The Fed can tinker with the short-term numbers, but the long rates reflect the true state of the economy and ultimately (IMO) will limit the Fed's ability to boost interest rates. That's what the flattening yield curve reflects.

Yep.

 

[NW-Bound]

... The amount of cash money in the US economy has traditionally been dwarfed by the amount of borrowed money in the economy, known as the credit multiplier. But that credit multiplier has been less than the money supply since the end of the 2008-'09 recession. https://fred.stlouisfed.org/series/MULT

Until that credit multiplier gets moving, the market is going to keep longer interest rates low. The Fed can tinker with the short-term numbers, but the long rates reflect the true state of the economy and ultimately (IMO) will limit the Fed's ability to boost interest rates. That's what the flattening yield curve reflects.

Not an economist, so I am trying to understand the implications of this.

Does this mean people/businesses do not need to borrow money, compared to earlier decades? Usually, the borrowers do so because they think they can earn more from investments than the interest that they pay.

If businesses have no need for money, are they out of ideas, or that there are no easy ways to make money? If so, how can stock earnings grow so that the share prices also grow as we investors like to see? Stocks will not do so well either then.

 

[Lsbcal]

...

Flattening yield curve implies lower 5-yr rate 5 years from today

Thanks for the equation. It is something I haven't seen.

Perhaps I should rephrase my comment on the yield curve. I am interested in the flattening of the yield curve because it has been correlated with recessions of the past. More specifically yield curve flattening is the first step towards inversion. Inversion has been correlated with recessions and stock declines of the past.

The yield curve was inverted before the 1929 crash. Also included in this correlation were the declines of 1969, 1973, etc. up through the 2008 stock decline. So the yield curve inversion is correlated with stock declines. There was a Fed paper on this some years back (could dig up the link if someone is interested). Note this doesn't mean as soon as you see inversion to go out and sell your stocks. It is not so precise a timing signal.

I imagine if someone had an equation that told us how the yield curve would be any time in the future, it would have so many unmeasureable variables that it would be useless in a practical sense. Being pragmatic in the extreme, I am content to just take the yield curve for what it is and not try to understand the economic details that push it around. Future interest rates, like the future, are unknowable.

 

[audreyh1]

Not an economist, so I am trying to understand the implications of this.

Does this mean people/businesses do not need to borrow money, compared to earlier decades? Usually, the borrowers do so because they think they can earn more from investments than the interest that they pay.

If businesses have no need for money, are they out of ideas, or that there are no easy ways to make money? If so, how can stock earnings grow so that the share prices also grow as we investors like to see? Stocks will not do so well either then.

There is little borrowing demand, other than to buy back shares.

Borrowing demand dropped drastically in 2008 and never returned to normal in spite of ultra low rates.

Little drives inflation at the moment (other than asset inflation).

Where will an increase in demand come from? Good question.

 

[ncbill]

doesn't a flattening yield curve also mean increasing likelihood of a recession?

 

[audreyh1]

doesn't a flattening yield curve also mean increasing likelihood of a recession?

It can. If the curve inverts then a recession is far more likely.

 

[NW-Bound]

Inflation/Interest rate goes up much, stock prices go down.

Inflation/Interest rate goes down much, stock prices go down.

 

[Lsbcal]

Here is a chart from the Fed database. Link: https://fred.stlouisfed.org/series/T10Y3M

The grey areas are the recessions. One problem in using this is that recessions aren't identified until months after they start. As I recall in 2008 the recession that started around December 2007 wasn't identified until late in 2008. Also stocks don't decline as soon as the yield curve inverts. There has been an irregular lag.

 

[audreyh1]

Here is a chart from the Fed database. Link: https://fred.stlouisfed.org/series/T10Y3M

The grey areas are the recessions. One problem in using this is that recessions aren't identified until months after they start. As I recall in 2008 the recession that started around December 2007 wasn't identified until late in 2008. Also stocks don't decline as soon as the yield curve inverts. There has been an irregular lag.

Right - it often takes a year to identify a recession. But not a bear market.

 

[Mr._Graybeard]

Not an economist, so I am trying to understand the implications of this.

Does this mean people/businesses do not need to borrow money, compared to earlier decades? Usually, the borrowers do so because they think they can earn more from investments than the interest that they pay.

If businesses have no need for money, are they out of ideas, or that there are no easy ways to make money? If so, how can stock earnings grow so that the share prices also grow as we investors like to see? Stocks will not do so well either then.

One area where borrowing has been very active is credit card debt -- it's right back to where it was before the 2008 recession. That puts a big burden on consumers and limits their ability to drive the economy. https://www.marketwatch.com/story/us-households-will-soon-have-as-much-debt-as-they-had-in-2008-2017-04-03

That hindrance is evident in durable goods orders, which have been largely flat since 2008 except for quarters where natural disasters require replacement of big-ticket items. Durable Goods Orders - Historical Chart | MacroTrends

Corporate profits, meanwhile, are at an all-time high at $1.8 trillion, jumping over $1 trillion since the bottom of the 2008 recession. In fact, aside from the 2008-09 bump, they've been on a rocket ride since 2001. https://fred.stlouisfed.org/series/CP

Tapping into the global marketplace has probably driven a lot of those profits, but much of that money was made by manufacturing stuff overseas and bringing it here for consumption. The question you have to ask is, "Is that sustainable?"

Our economy has been consumer driven since at least the end of World War II. It's a ominous development (IMO) if consumers are once again strapped for money.

As an investor in his 60s, I've been playing defense for quite awhile. My equity holdings are mostly on the value side with most of our holdings in fixed income. I hear arguments that stocks tend to come back after they crash, but the bear market of the 1970s lasted a decade. I don't have that many decades left to wait for a rebound.

Just my perspective. Hope I don't sound too gloomy.

 

[audreyh1]

Wages have also grown very slowly. This also straps the consumer. This is seriously limiting demand.

 

[LiveBelowMeans]

I think demographics play a huge part in this. Baby boomers are retiring and demand will be muted for years. Think Japan. Only way to boost demand in my opinion is to increase birth rate or immigration. I suspect we will be dealing with low interest rates for years to come. JMHO

 

[audreyh1]

I think demographics play a huge part in this. Baby boomers are retiring and demand will be muted for years. Think Japan. Only way to boost demand in my opinion is to increase birth rate or immigration. I suspect we will be dealing with low interest rates for years to come. JMHO

That's my gut instinct.

 

[Lsbcal]

...
As an investor in his 60s, I've been playing defense for quite awhile. My equity holdings are mostly on the value side with most of our holdings in fixed income. I hear arguments that stocks tend to come back after they crash, but the bear market of the 1970s lasted a decade. I don't have that many decades left to wait for a rebound.

Just my perspective. Hope I don't sound too gloomy.

You do sound a bit gloomy. But I totally understand your focus on periods like the next 10 years.

Note that bonds didn't really protect you in the 1970's with all that inflation. But nowadays we have inflation indexed products that can give us at least a reading on what is available. So currently the 5yr TIPS are at 0.4%. Going with intermediate term investment grade (duration about 5 years), one should be able to get better real returns with the risk that unexpected inflation occurs and reduces returns. But then again, over a 10 year period, the markets would adjust and so the loss to inflation might be a temporary hiccup.

 

[Mr._Graybeard]

Actually, I remember my mom and dad getting yields of 12%-plus on CDs in the '70s. Here's a chart. Check out those rates circa 1980, when Volcker was really putting the boots to inflation! People with money in the bank were cleaning up.

The folks who got hurt back then were folks who were in debt. Can you imagine taking out a mortgage when the prime was 16.75%? When DW and I bought our first house in 1988 I remember feeling pretty good that we got a rate of 9.5% with no points up front. Of course it was only a 5-year balloon ... fixed-rate notes were higher.

 

[Lsbcal]

Just a point on debt and inflation. We got a mortgage on our first house in 1975. I don't remember the interest rate but it was clear at that time that inflation was bad and not looking like it would go away. In inflationary times you want a fixed rate mortgage. The banks got creamed, the debtors made out like bandits. Real estate really did well in our area (Silicon Valley).

 

[audreyh1]

The flattening curve indicates that even though short term rates are rising, intermediate and long term rates aren’t moving much. In fact the longest have dropped compared to a year ago.

It can give someone adding to intermediate bond fund some peace of mind.

Of course things could change in a year! Like if the economy takes off.

But, the current pattern is matching the last one with gradual flattening.

 

[Running_Man]

Personally, I watched today’s action in the 5 year bond market and came to the conclusion that the 16 year decline in interest rates on the intermediate basis was ended today and an uptrend is beginning to exert itself. One cannot judge historically any flattening of the yield curve when the Federal Reserve is unwinding trillions of short term bonds and raising the rates, it is not the same FED that existed for 100 years of existence.

However, the 5 year treasury has more than doubled in 6 months from 1 percent to 2.14. If the 5 year was to double again in interest rates in the next 6 months we will be looking at a 4 1/4 percent 5 year treasury.

My personal belief is this article is absolutely as wrong as could be, I came to the conclusion in September that interest rates were going to accelerate and the 5 year breaking out to me, if it is not reversed very quickly here, is a sign the FED is starting to lose control of the markets they hold so dear

 

[Lsbcal]

..

However, the 5 year treasury has more than doubled in 6 months from 1 percent to 2.14. If the 5 year was to double again in interest rates in the next 6 months we will be looking at a 4 1/4 percent 5 year treasury.
...

Not quite right on the 5 year Treasury. Here is the Fed chart:
https://fred.stlouisfed.org/series/DGS5