Posts Tagged ‘yield curve’

Dead man’s curve?

3 August 2011

Scott Sumner’s blog The Money Illusion has two provocative posts today that argue that Federal Reserve policy is currently too tight, despite the near-zero fed funds rate, and cite as evidence the extremely low interest rates on 5-year Treasury notes. I’m going to grapple with his monetary policy argument at some later date (the gist of it seems to be that the Fed should target nominal GDP and therefore combat the current slump with much bigger increases in the money supply than we’ve had). For now I want to focus on those 5-year bond rate data, which are bad news indeed.

The most recent 5-year bond yield, as of yesterday, was 1.26%. That’s close to a historic low. What does it mean? The standard interpretation in a money and banking course is that interest rates on 5-year bonds are the average of current and expected future short-term bond rates over the next 5 years (since a close substitute for a 5-year bond is a series of short-term bonds held over the same span), with some allowance for people’s preference for short-term bonds as more liquid (you get your money back sooner) and less risky (you don’t have to worry about market interest rates shooting up after you’ve bought your bond and then being stuck with a subpar yield for a long time). So, the number suggests that people are expecting very low short-term bond yields over the next five years. Short-term interest rates are a function of two big things: the state of the economy (they’re lower in economic slumps) and the expected inflation rate (when inflation falls, lenders and bondholders will accept lower interest rates; and inflation also tends to be lower in economic slumps). And in the case of T-bonds, the interest rates reflect the jitters of worldwide investors — the more nervous investors are about stocks and corporate bonds, the more likely they  are to flee to the safety of Treasuries.

So, then, a near-record-low 5-year T-bond rate means investors are expecting (1) economic weakness for the next 5 years and/or (2) low inflation for the next 5 years and/or (3) investor anxiety for the next 5 years. I’d vote for all of the above. And (2) and (3) are common symptoms of (1).

To see just how low these recent 5-year Treasury yields are compared with those of the past nine years, see this Dynamic Yield Curve, which shows the interest rates on T-bonds of different maturities.  If you click Animate, yield curves from 2003-present flash by and you’ll see that that the norm for 5-year rates is about 3 to 5%. So the bond market apparently expects the economy to be way below average for the next five years. Even the 10-year bond rate was only 2.66% yesterday (it’s normally above 4%), so a ten-year depression is not only possible but maybe even probable, according to the market.