Yield Curve_Dec 2009

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Risk over Reward A Weekly Newsletter about Investing

The Yield Curveby Alpha and Vega, an Investor and a TraderDecember 13th, 2009

In this issue:1) Basic Theories of the Yield Curve2) Basics In Action3) What has the Yield Curve Told Us in the Past?4) Is the Yield Curve "Smart"?5) Chinese Demand

Dear Friends, Colleagues, and Investors:

The yield curve is the collection of interest rates offered by Treasury securities at various maturities (see graph below for current yield curve). The yield curve has historically provided a great deal of information about the future of the economy. The New York Federal Reserve regards it as a valuable forecasting tool in predicting recessions about a year ahead of time; it's been consistently more accurate at predicting recessions than professional economists over the last 30 years. Today the yield curve appears to be pricing in moderate growth and little inflation, while the equity and commodity markets appear to be pricing in robust growth and significant inflation. In this newsletter I'll explore the Treasury yield curve and explain what

it's telling us today.

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1) Basic Theories of the Yield Curve

The yield curve refers to the relationship between the interest rate on debt versus the maturityof the debt. For a bond, the higher the price, the lower the yield. There are a few differentways to think about the yield curve, each of which contributes to our understanding.

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and scary, they’re likely to accept a lower re turn in exchange for the safety of Treasurysecurities.

The effect of "Preferred Habitats" is more subtle. This point is debatable, but I believe that asChina has become a large but reluctant buyer of treasuries over the last decade, their

preference for shorter-term debt has reduced short-term rates relative to long-term rates.

3) What has the Yield Curve Told Us in the Past?

An inverted yield curve usually precedes a worsening economic situation. For example, inAugust of 1981, the yield curve was inverted, meaning that short-term interest rates werehigher than long-term interest rates. The next year saw a severe recession and stock marketcorrection. In April of 1992, the yield curve was steep with long-term bonds yielding 5% morethan short-term bonds; the bond market was correctly anticipating robust growth and the stockmarket performed well over the next couple years. The graph below shows that the yield curve

has become inverted about a year before every recession since 1950. You may also noticethat there have been a few "false alarms" where the yield curve became inverted but norecession followed.

In the 1920s, the yield curve inverted in both 1923 and 1927, so its success rate as a

recession predictor was only 50/50. From 1934-1950, the yield curve never inverted; it failedto predict 3 recessions (see graph below).



4) Is the Yield Curve "Smart"?

Why is the yield curve a useful tool in prediction recessions and equity returns?

One hypothesis is that bond investors are simply “smarter” than equity investors. Mom & Popgamble on stocks in their retirement accounts, while bond trading is generally reserved forfinancial professionals. Perhaps bond investors can somewhat accurately predict recessionsand their opinions are reflected in the bond market earlier than in the equity market.

Another possible explanation is that the shape of the yield curve directly impacts economicgrowth. For example, with a very steep yield curve, banks can easily produce great profits.

They effectively “borrow” short-term via deposits and lend longer term via loans or buyingtreasuries. If the yield curve is steep they may be able to pay depositors 0.25% and then buytreasuries yielding 5% for easy profits. If the yield curve is inverted, it becomes extremelydifficult for banks to make money.

A final and often ignored factor is that the shape of the yield curve is a reflection of recentactions of the Federal Reserve. Long-term interest rates tend to be anchored as investorscorrectly believe that interest rates revert to a common mean over many years. So, if theFederal Reserve reduces short-term interest rates, this is likely to produce a steeper yieldcurve; this effect is strengthened by the fact that lower short-term interest rates may increaselong-term inflation expectations, which helps prevent the yield curve from falling in parallel. A

steeper yield curve correlates to higher economic growth, but that may be a "confoundingvariable." Perhaps the growth is coming purely from the lower short-term interest rates, andthe steeper yield curve is a byproduct. Similarly, a flat yield curve frequently occurs after theFederal Reserve raises short-term rates which has the effect of depressing growth. In otherwords, it may be the change in short-term interest rates that matters; the change in the yieldcurve is a byproduct of long-term interest rates moving less than short-term interest rates.

Each of the three explanations above is probably somewhat true and contributes to our



empirical observation that the shape of the yield curve does a good job of predictingrecessions.

5) Chinese Demand

A unique dynamic exists today that we must consider when extrapolating from the past. Ourunprecedented trade imbalance with China makes them captive Treasury buyers. WhenAmericans import more than we export, foreigners are left holding US dollars. Our greatesttrade imbalance is with the Chinese who have been extremely risk averse with their dollarholdings. The Chinese government has maintained the trade imbalance by pegging theircurrency to ours to support their export sector. By pegging their currency, they’veaccumulated about $4 trillion US dollars. Some of that money is kept in simple currency, butthey’ve used about $800 billion to buy treasuries. Maybe they’re thinking that a 2% yield, whilesmall, is still better than nothing. Maybe they’re thinking that by lending us the money they aresupporting the value of the total $4 trillion of US dollars they hold. Regardless, the Chinesepolicy decision to maintain the trade imbalance has the side effect of making them bigTreasury buyers almost regardless of yield. They are rightfully concerned about thesustainability of our deficit though, so most of their Treasury holdings are short and medium-term. Under the "Preferred Habitat" lens, this means that the biggest marginal buyer of ourtreasuries does not want to hold our long-term debt. The result is that the price of our long-term debt drops relative to our short-term debt which means that the long-term yield rises; theyield curve steepens.

Economists who reject the "Preferred Habitat Theory" argue that the current yield curve meansthe market is predicting modest economic growth. While the yield curve throws doubt on theequity and commodity markets, it still appears more sanguine than many analysts. However, ifthe "Preferred Habitat Theory" is the dominant dynamic, the yield curve may not be ameaningful predictor today at all; without the large trade imbalance, perhaps the yield curvewould be flatter today.

Your "Upward Sloping" Trader, Vega [email protected]

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Yield Curve_Dec 2009