The yield curve has a funny shape. But not funny enough.
In the last week, a portion of the yield curve has inverted, meaning some long-term interest rates are lower than some intermediate-term interest rates. Specifically, the 30-year Treasury bond's yield has dropped below the 10-year Treasury note's. It's the first time since late 1994 that that's happened, and the first time since mid-1990 that it's been sustained for more than a day. Yesterday, the 30-year bond closed with a yield of 6.75% while the 10-year note ended the day with a yield of 6.79%.
People read things into yield curves, and it's true that, in the past, a flat or inverted yield curve has coincided with the end of a bear market in bonds, or heralded an economic slowdown sometime during the year ahead, or both.
Any or all of which might occur. But before you go loading up on bonds, there are a few things you might want to consider.
The first is that the difference in yield between the 30- and 10-year Treasuries has collapsed due at least in part to supply-and-demand dynamics. Some go so far as to say that supply-and-demand dynamics alone account for the collapse.
Two key events have at least contributed to the more-or-less steady contraction in the difference in yield between the 30-year bond and the 10-year note since August. The first was the
announcement that it would decrease the frequency of its 30-year bond auctions to two times a year from three. It was merely the latest in a series of cutbacks the department has made to its auction schedule over the last several years, as the federal budget deficit has turned into a surplus.
Treasury market analysts expected the move, but they hadn't expected it so soon. So the increased scarcity of 30-year bonds boosted their value relative to 10-year notes, which are more plentiful. The yields of both rose pretty steadily last year, but the 30-year's yield rose substantially less.
The 30-year's outperformance of the 10-year accelerated last week, after the Treasury Department
announced that it will begin buying back some old Treasury securities from investors during the first half of this year. The buybacks are an alternative to further reducing the auction schedule, which impairs liquidity.
The announcement further increased the value of 30-year bonds relative to 10-year notes because the buyback program is expected to target long-maturity Treasuries, which are the government's highest-interest debt. The program had been in the works for months, but the announced size of it -- as much as $30 billion could be bought back this year -- was larger than the $10 billion to $20 billion most market analysts were expecting.
The reduced auction schedule and the buyback program "are factors that were expected to depress if not invert" the Treasury yield curve between 10 and 30 years,
chief economist Lou Crandall says. "The only surprise is that it took as long as it did to happen."
Some investors will continue to buy the 30-year bond, even though its yield is lower than the 10-year note's, because they require long-duration assets,
senior fixed-income strategist Michael Ryan explains. "We have a diminishing pool of long-duration assets, but continued demand from pension funds and insurance companies, who are long-duration buyers," he says.
The second thing you might want to consider is that the 10- to 30-year segment of the Treasury yield curve is the
portion to have inverted, or even to have flattened. As this chart shows, the entire yield curve -- from the two-year note to the 30-year bond -- has held pretty steady at around 25 basis points, while the front half of the curve, the two-year to 10-year portion, has steepened markedly.
Source: Federal Reserve
This is important because it distinguishes this inversion of the 10- to 30-year portion of the yield curve from its inversions in 1994, when both halves of the curve flattened in sympathy, as this chart shows.
... And Then
Source: Federal Reserve
The point is, what's happened in the last week isn't comparable to what happened in late 1994, when the inversion of the 10- to 30-year portion of the curve marked the end of the bear market. Then (and in 1990), the entire curve flattened as the two-year note's yield rose sharply while the 10- and 30-year yields held relatively steady. This time, it's the 10-year note's yield rising relative to the wings of the curve.
"In general, it's been the intermediates cheapening relative to everything else," says Mark Mahoney, Treasury market strategist at
Warburg Dillon Read
. Meanwhile, Mahoney said, the two-year note's yield has stayed relatively low because it tends to track the
fed funds rate
, and in a speech last week,
indicated that the Fed would continue to take a gradual approach to raising the key rate.
"If we get a complete flattening of the yield curve, that has informational value, but sectors can be dominated by supply-and-demand dynamics," PaineWebber's Ryan says.
'No Predictive Value Whatsoever'
Finally, there is the question of how much informational value even a flattening of the entire yield curve has.
Historically, flattenings of the spread between money market interest rates like the fed funds rate and the three-month Treasury bill yields and the 10-year Treasury note have been associated with an increased probability of a recession within the next year. The logic is that since the magnitude of that spread is determined primarily by the fed funds rate, the spread will flatten when the Fed is hiking rates and steepen when it is cutting them.
But for much of this decade, that spread has been very flat by historical standards, with no pause in economic growth. Crandall goes so far as to say the spread has had "no predictive value whatsoever throughout the '90s."
He says that's because as the bond markets have grown, long-term interest rates have become more crucial to the economy than short-term ones. "You can now argue that bond yields are a cause of future economic activity, rather than a predictor of it, making a steep yield curve something that should prevent future growth," he says.
As for whether the current slope of the yield curve says anything about where interest rates are headed, Crandall warns: "Rules that the market knows about aren't supposed to work."