Financial Gravity and the Yield Curve

Isaac Newton sure was on to something with that whole First Law of Motion thing: Trends in motion tend to stay in motion.

And no trend has been more enduring and powerful since early 2004 than the flattening of the yield curve, a topic last addressed here in May.

The rapidity and power of the yield curve changes over the past five years is difficult to comprehend.

The Federal Reserve conducted a great experiment in driving short-term interest rates lower between 2001 and 2003. The yield curve steepened under this monetary onslaught; long-term rates didn't tumble as much as the market began pricing inflation into the mix.

Once this experiment ended, the flattening of the yield curve that's still under way proceeded, as Newton would have predicted, in an equal and opposite fashion.

We can illustrate this with the forward-rate ratios between various points on the yield curve. The forward rate between, say, two and 10 years is the rate at which you can borrow money for eight years beginning two years from today. If the ratio between this forward rate and the 10-year rate itself exceeds 1.00, the yield curve is positively sloped. Levels less than 1.00 indicate an inverted yield curve.

Incredibly, there are people who can look at the chart below and debate when we're headed for an inversion.

Here's some free advice: When you fall out of a window, skip the debate on whether you'll hit the ground or not. Newton had that gravity thing down, too.

Get Ready to Invert

Source: Bloomberg

Europe Joins the Party

Jean-Claude Trichet of the European Central Bank, possibly motivated by my merciless taunting two week ago -- I'm certain he had to answer for my "les poulets" gibe -- made it clear this past Friday that short-term interest rates were going to rise in the eurozone. Interestingly, the bond market in Europe began pricing in a flatter yield curve at the end of March 2004; the forward rate ratio for European sovereigns over the two- to 10-year segment has been flattening and flattening at an accelerating rate since then.

We can make no parallel statement for the six- to nine-month segment of the yield curve, the money market segment related most directly to the currency market. This has been moving both in a steepening and flattening fashion regardless of official ECB policy and in a manner unrelated to longer segments of the yield curve. It should be safe to assume the European money market curve will flatten as ECB policy tightens, but you would be amazed to learn what Isaac Newton had to say about "assume."

Euro Yield Curve Has Been Flattening at Long End

Source: Bloomberg