07-07-2021, 10:58 AM
(07-07-2021, 07:59 AM)John J. Xenakis Wrote: ** 07-Jul-2021 World View: Bond yields
Lots of panic on CNBC this morning because 10 yr bond yields are
falling to 1.3%, with the fear that they will fall to 1% by the end of
the week.
What people must beware is the inverted yield curve in which long-term yields are lower than short-term yields. Very short-term yields make short-term borrowing more expensive, which discourages borrowing for starting new businesses. Speculative activity may be high and approaching the collapse.
Quote: The shape of the yield curve changes with the state of the economy. The normal or upward sloping yield curve occurs when the economy is growing. Two primary economic theories explain the shape of the yield curve; the pure expectations theory and the liquidity preference theory.
In pure expectations theory, forward long-term rates are thought to be an average of expected short-term rates over the same total term of maturity. Liquidity preference theory points out that investors will demand a premium on the yield they receive in return for tying up liquidity in a longer term bond. Together these theories explain the shape of the yield curve as a function of investors’ current preferences and future expectations and why, in normal times, the yield curve slopes upward to the right.
During normal periods of economic growth, and especially when the economy is being stimulated by low interest rates driven by Fed monetary policy, the yield curve slopes upward both because investors demand a premium yield for longer-term bonds and because they expect that at some point in the future the Fed will have to raise short-term rates to avoid an overheated economy and/or runaway inflation. In these circumstances, both expectations and liquidity preference reinforce each other and both contribute to an upward sloping yield curve.
When signals of an overheated economy start to appear or when investors otherwise have reason to believe that a short-term rate hike by the Fed is imminent, then these theories begin to work in the opposite directions and the slope of the yield curve flattens and can even turn negative (and inverted) if this effect is strong enough.
Investors begin to expect that the Fed’s efforts to cool down the overheated economy by raising short term rates will lead to a slowdown in economic activity, followed by a return to a low interest rate policy in order to fight the tendency for a slowdown to become a recession. Investors expectation of falling short-term interest rates in the future leads to a decrease in long term yields and an increase in short term yields in the present, causing the yield curve to flatten or even invert.
It is perfectly rational to expect interest rates to fall during recessions. If there is a recession, then stocks become less attractive and might enter a bear market. That increases the demand for bonds, which raises their prices and reduces yields. The Federal Reserve also generally lowers short-term interest rates to stimulate the economy during recessions. That expectation makes long-term bonds more appealing, which further increases their prices and decreases yields in the months preceding a recession.
Historical Examples of Inverted Yield Curves
- In 2020, the yield curve briefly inverted on Feb. 25. Signals of inflationary pressure from a tight labor market and a series of interest rate hikes by the Federal Reserve from 2017 to 2019 raised expectations of a recession, exacerbated by initial coronavirus concerns. Those expectations eventually led the Fed to walk back the interest rate increases. This inversion of the yield curve signaled the onset of recession during 2020.
- In 2006, the yield curve was inverted during much of the year. Long-term Treasury bonds went on to outperform stocks during 2007. In 2008, long-term Treasuries soared as the stock market crashed. In this case, the Great Recession arrived and turned out to be worse than expected.
- In 1998, the yield curve briefly inverted. For a few weeks, Treasury bond prices surged after the Russian debt default. Quick interest rate cuts by the Federal Reserve helped to prevent a recession in the United States. However, the Fed's actions may have contributed to the subsequent dotcom bubble.
The ideal subject of totalitarian rule is not the convinced Nazi or the dedicated Communist but instead the people for whom the distinction between fact and fiction, true and false, no longer exists -- Hannah Arendt.
