Today's Inverted Yield Curve Is Not a Signal of Approaching Recession

Daniel Gross writes about the inverted yield curve:

The Dread "Inverted Yield Curve" - It makes brave economists cower. By Daniel Gross : On Tuesday, the placid post-Christmas markets were rattled by news that interest rates on two-year bonds nudged higher than those for 10-year bonds. This was the dreaded inversion of the yield curve, and it sent the markets running. Why? Traditionally, inverted yield curves signal bad news for the economy--and hence for stocks... "this is a warning signal... that we are on recession watch now." Recession watch? You don't have to be a jolly optimist to believe that was an overreaction.... [T]he inversion thesis will likely be disproved in 2006. Just because a portion of the yield curve inverts, it doesn't mean the economy is poised to make like the S.S. Poseidon...

Usually an inverted yield curve is the result of a lot of domestic investors' thinking the Fed is going to cut short-term interest rates over the next couple of years, and so buying medium- and long-term bonds to lock in higher yields and reap hoped-for capital gains as interest rates fall. What makes the Fed cut short-term interest rates? A recession.

This inversion of the yield curve, however, is generated not by domestic investors' thinking that a recession is on the way, but by foreign central banks' desires to keep buying lots of dollar-denominated bonds in order to keep their currencies from appreciating.

Thus while an inverted yield curve is usually a sign that a bunch of people are trading bonds on their belief that a recession is likely, that is not what is going on in this case.

Comments

[MjrMjr]

What length(not sure of the correct term) of bond do foreign central banks prefer and why? Do they quickly switch to shorter term bonds once the yield curve inverted? i.e. start buying 5 yr bonds once they'd depressed the yield on the 10 yr to below the 5 yr?

I think I understand what Brad is saying re:domestic investors buying medium-long term bonds if they think a recession will hit. Lock in whatever the rate is then they're guaranteed a relatively good rate of return as interest rates get cut during the recession. Do foreign central banks have a preference for medium-long term bonds and if so what is their reason?

[Michael Robinson]

Brad: "This inversion of the yield curve, however, is generated not by domestic investors' thinking that a recession is on the way, but by foreign central banks' desires to keep buying lots of dollar-denominated bonds in order to keep their currencies from appreciating."

Exactly right.

In the current inversion of the yield curve, the recession will happen /after/ the foreign central banks lose their desire "to keep buying lots of dollar denominated bonds".

Because what does a falling dollar do in an import-driven asset-bubble economy? It causes inflation. And what makes the Fed raise short term interest rates? Inflation. And what causes the bond market to bid up long term rates? A shortage of buyers. And what do high rates cause? Economic slowdown.

And to make it even more interesting this time around, what does economic slowdown cause? Among other things, demand destruction for petroleum products.

See Brad Stetser for how much of the current dollar-denominated debt buying spree is currently being driven by windfall profits in petrodollar economies.

Also making thing interesting this time around are record U.S. debt-service ratios. Economic slowdown also results in higher default rates, which also pushes up the cost of lending.

People who fear the current minor inflection in the yield curve fear exactly the wrong thing. They fear low long-term rates, when they should fear high long-term rates.

[SERO]

So, "It's different this time", according to Messrs Gross and De Long ?
Fine, no harm ever came from thinking that.

[wkwillis]

It's always different when the boom is over, even if it's not different when the boom is on.
1900 to 1915 was different from 1930 to 1940 was different from 1965 to 1975 was different from 2000 to ?
Inflationary depressions, deflationary depressions, hyperinflationary depressions, etc. All different.

[liberal]

MjrMjr wrote, "What length(not sure of the correct term) of bond do foreign central banks prefer and why?"

Not sure but ISTR that the Chinese like relatively short durations (maybe 2 yr).

[Jonathan King]

OK, so here's the objective data again:

http://www.treas.gov/offices/domestic-finance/debt-management/interest-rate/yield.html

...and there's lots of historical data out there, too. In any case, there's no question that the recent inversion happened because long term rates *declined* over the last month (despite the fact that mortgage rates moved the other way). Another screwy thing that happened was that 1-month rates went down 48 basis points over the course of 3 weeks, and then went up 52 basis points in three days.

The whole situation is weird, and now I don't have any idea what will happen.

[jim]

Is it normal to see major differences between the Treasury yield curve and Corporate yield curves? The yield curve inversion is confined to Treasuries. Short AAA Corporates are a handful of basis points above short Treasuries, but long AAA Corporates are pushing 5.75%.

I assume foreign central banks are sticking to Treasuries.

[piotr]

Stupid questions:

if "Chinese like short durations", while high prices of long bonds? Could it be an artifact of Treasury policy that offers few new long bonds?

In any case, it is clear that foreign demands on Treasury, like any source of demand, increases the prices, but it is not clear why it should invert the yield curve, except that central banks have very different calculations than normal bond buyers --- they do not maximize yield of the portfolio.

[s9]

Is it really the foreign central banks responsible for the high demand of 10-year treasury notes? I seem to recall seeing recent data showing that private investors have been responsible for an increasing share of that flow this past year.

I understand that foreign governments are still trying to prop up their currencies, but they've been announcing all along their intentions to move gradually away from that strategy. If foreign banks have been reducing their demand, but private investors have been taking up the slack, what does that mean?

[kharris]

S9 has a good point, and MirMir has a good question. Offering central bank activity as the single cause of inversion strikes me as over-simplification. There has been a substantial shift in demand for US assets from official sources to private sources this year. And central banks do tend to prefer shorter dated securities. Those two circumstances surely raise doubts about central banks participating sufficiently in demand for US long-end Treasuries to have much impact. Seems more likely flattening is due to a number of factors, with central banks maybe not a very big one.

Dutch pension funds don't have a currency ax to grind - at least, not to the point of attempting to manipulate currencies - but they know there is a change in law coming that will require greater duration of assets. US pension managers have heard suggestions of similar changes. In the face of that likely increase in demand for long-dated debt, there will be a US T-bond auctioned this year, but in very modest amounts.

If inflation were running at 5.5%, and investors had a creepy feeling the Fed (and BoC and BoJ and ECB and BoE) wouldn't do much about it, the curve would be a good bit steeper, all else equal. Given the rate of inflation implied in ten-year tips, is the inflation-expecations-adjusted curve really flatter than we would expect it to be after 325 bps of rate hikes from the Fed, with more to come?

[Sean Matthews]

Seems to me that '...foreign central banks' desires to keep buying lots of dollar-denominated bonds in order to keep their currencies from appreciating' have driven the American economy into areas where nobody has ever been before (except if you live in somewhere like Argentina).

When even the BDLs of the world are saying things like this, it looks to me like Rudi Dornbusch's rule (which I think you, Brad, have quoted on several occasions), is really getting ahead of Keynes old warning - and that it truely is time to start accumulating dollar puts.

[Winslow R.]

Another inverted yeild curve discussion with no reference to (understanding of?) the 'carry trade'.

[nate]

it depends

[liberal]

Winslow R. wrote, "Another inverted yeild curve discussion with no reference to (understanding of?) the 'carry trade'."

Huh. I was going through the comments and about to ask about hedge funds/carry trade, then got to this one.

[Winslow R.]

Brad wrote:

"Usually an inverted yield curve is the result of a lot of domestic investors' thinking the Fed is going to cut short-term interest rates over the next couple of years, and so buying medium- and long-term bonds to lock in higher yields and reap hoped-for capital gains as interest rates fall. What makes the Fed cut short-term interest rates? A recession."

This is a myth. Smart investors don't lose money in the present to make money in the future.

"This inversion of the yield curve, however, is generated not by domestic investors' thinking that a recession is on the way, but by foreign central banks' desires to keep buying lots of dollar-denominated bonds in order to keep their currencies from appreciating."

Agreed, foreign CB's can buy because they have no need to borrow to lend, they control 'dollar flows' from America. The 'rich' (those with money and no need to borrow) always continue to lend.

"Thus while an inverted yield curve is usually a sign that a bunch of people are trading bonds on their belief that a recession is likely, that is not what is going on in this case."

It never is (except for a few dumb? investors). The simple fact lending falls off after a yeild curve inversion should make this obvious.

[Howard]

kharris, since you bring up the TIPS, here's an interesting factoid for which i don't have an explanation.

For quite a while (easily a year or so), the TIPS rate was in the neighborhood of 1.5 l- 1.6. Then, in the last 3 months, it moved up to 2.1 - 2.2.

In a world of capital abundance, i find it rather amazing that the cost of TIPS should be going up, considering there is no inflation risk in owning TIPS. So what does it mean?

My best bet is that it represents a hedging of bets by TIPS buyers....

[anne]

These 6 years have been a sensational bull market in long term bonds for domestic and international ivestors. Vanguard long term bond index has averaged about 10%, while the S&P stock index return has been about 0. The difference between bond and stock returns has been greater in favor of bond than in any comparable period since the Depression.

[john c. halasz]

Emm...it looks like there are signs of the housing boom reaching its top. What about that other rule-of-thumb that recessions tend to lag the end of housing booms by about 8 months?

[brad setser]

Five points:

1) Japan, far more than China, traditionally has held a conservative reserve portfolio of short-duration treasuries.
2) I would be surprised if China does not hold Treasuries out to ten years. But I don't think there is good objective data on this.
3) The objective data available shows that China is putting about 1/3 of its new reserves into Treasuries, 1/3 into agencies and 1/3 into corporate bonds (corporate bonds include mortgage-backed securities). That suggests to me that China is willing to extend the duration of its reserve portfolio as well as take on a tiny bit of credit risk for a bit more yield.
4) Official inflows to the US are down significantly, and private flows are up, tis true. But a couple of note of caution are in order. The official data suggests that only 40% of China's $250 b or so reserve increase is flowing into the US/ next to none of Russia's $60 billion reserve increase/ and truly none of Saudi Arabia's $65 billion or so increase in the "official assets" of the Saudi monetary authority is flowing into the US. That doesn't seem likely -- so while there is no doubt that private demand for US bonds has picked up, I personally doubt the fall off in official demand is as large as the US TIC data suggests (the TIC data has lots of problems). Basically, the TIC data picked up Japan's reserve purchases, but is not picking up official or quaisi-official (Abu Dhabi investment authority, Russia's oil stabilization fund) inflows to the US from the oil states. So the shift in official asset accumulation from Japan to the oil exporters has led a sharper fall off in reported official demand for US assets than I suspect is really the case.
5) China, S. Arabia, Abu Dhabi, Russia's oil fund (if not the Bank of Russia) etc all probably buy (through intermediaries) a broader range of US assets than just treasuries -- i.e. they treat their reserves/ oil funds a bit more like an investment portfolio and a bit less like classic have to be very liquid reserves.

So i don't find it implausible than the combinaiton of China, several other emerging economy central banks that are still adding to their reserves and the oil states quasi-official investment bodies are combining to hold yields at the back end of the curve down.

Sorry about the length of this.

[brad setser]

I should add that if Bill Gross of PIMCO is talking his book, he too has been buying the long-end of the curve in anticipation of peak fed funds and future fed cuts.

[anne]

Notice the condition of developed economies this last year, housing booms and relatively come and gone, there have been relatively energy shocks, yet growth has been fair and more in every economy, and international stock markets in domestic currencies have been terrific. I could sure make a case for worrying, and yet :)

[kharris]

Winslow,

You're assertion that an inverted curve "never is" a sign that investors anticipate a recession is, let's say, idiosyncratic. A good many people who make their living in financial markets share Brad's view of the inversion-recession link in at least some instances, so it would be nice if, rather than just dismissing a widely held view, you try to actually make a case against it. What you've offered here doesn't seem to do that.

Similarly, asserting that "smart investors" don't lose money in the short term to make money in the long term seems to argue that "smart investors" don't take risks. My understanding is that they do take risks, just like dumb investors. Just because you wouldn't do it doesn't mean no smart person would, or that one would routinely lose money by buying long-dated paper when the curve is flat. A simple test would be to look at prior instances of flat or inverted curves and see how they steepened up again. If long-end yields rise before short end yields fall in most cases, then holding long paper when the curve is flat is a bad idea. If the short end moves first, then holding long paper pays.

Here's a hint. Rumor has it that the long end traditionally rallies when the Fed finishes a cycle of rate hikes.

One more thing. Just because carry trades weren't mentioned in this discussion does not mean people who frequent this place are unaware of it. No need to be snide. It just brings out snide behavior in others.

[anne]

An inverted or flat yield curve has continually been a mark of an economy expected to slow significantly, and precisely the thing to do at that point is lost money in the short run by buying long term bonds in anticipation of falling interest rates. The long term bond market since 1981, by the way, has been sensational by historical standards. The problem here, however, is we are running low on yield :)

[anne]

TIPS, by the way, were somewhat limited in supply and highly marketed by investment houses to retail investors. TIPS had become too pricey in 2004.

[Bruce Wilder]

I remain skeptical about the optimism on the yield curve inversion. The yield curve is not just an indicator of investor expectations or sentiment; it is also a mechanism: the banking system traditionally borrows at short-term rates to lend at long-term. There is a squeeze on banks inherent in an inverted yield curve.

[Winslow R.]

Kharris wrote:
You're assertion that an inverted curve "never is" a sign that investors anticipate a recession is, let's say, idiosyncratic.

*Kharris, I admire your stuff, I think we have a misunderstanding. Investors are forced out of the lending market by lack of profit there is no need to anticipate a recession. Savers stay in because they do not borrow at FF rate to lend.

A good many people who make their living in financial markets share Brad's view of the inversion-recession link in at least some instances, so it would be nice if, rather than just dismissing a widely held view, you try to actually make a case against it. What you've offered here doesn't seem to do that.

* I have not dismissed the inversion-recession link, Brad has. I dismiss his cause of the inversion. It is important to diffentiate between 'investors', those that borrow to lend from 'savers' those that control dollar flows. To say this time is 'different' and a yeild curve inversion would not cause a recession is dangerous and delusional.

“Similarly, asserting that "smart investors" don't lose money in the short term to make money in the long term seems to argue that "smart investors" don't take risks. My understanding is that they do take risks, just like dumb investors. “

*Smart car companies don't build auto plants that will have negative cashflows. Smart investors don't bet against the Fed, smart savers might if they have other interests (China CB). Would you make investments with negative cashflow (stocks, real estate)? Would you consider borrowing on your HELOC at 7.5% and using it to buy a bond paying 7%? There are too many better ways to make money if your willing to wait.

Just because you wouldn't do it doesn't mean no smart person would, or that one would routinely lose money by buying long-dated paper when the curve is flat. A simple test would be to look at prior instances of flat or inverted curves and see how they steepened up again.

*If you don't believe me, look at the quantity of investor lending as the curve flattens and inverts. Hint – it falls off as is now happening. Check out H.8 at the Fed.

*Line 1 see growth for past 3 months
http://www.federalreserve.gov/releases/h8/20051223/

*Past cycles check out
http://research.stlouisfed.org/publications/mt/19980501/cover.pdf#search='invert%20eurodollar'

If long-end yields rise before short end yields fall in most cases, then holding long paper when the curve is flat is a bad idea. If the short end moves first, then holding long paper pays.
Here's a hint. Rumor has it that the long end traditionally rallies when the Fed finishes a cycle of rate hikes.

*If the lt rises before st falls then the Fed/Gov has redistributed wealth sufficiently to cause an economic renewal and even possibly inflation. If st moves first (which my guess is what will happen this time) then Fed/Gov has failed to redistribute wealth sufficiently to sustain an economic renewal and will have to resort to lowering st interest rates further.

One more thing. Just because carry trades weren't mentioned in this discussion does not mean people who frequent this place are unaware of it. No need to be snide. It just brings out snide behavior in others.

*To suggest 'this time is different' is dangerous. To suggest a yeild inversion will not lead to a recession is dangerous. We need the carry trade to function as it has in the past. If we do not want a recession we need the carry trade and it has already started to stop functioning, to say otherwise requires the proof.

[glenn]

15 months, more or less. That's when the piper gets paid. 4-6 quarters on average after inversion is when recessions officially begin, though we should be able to see it happening a bit sonner that that. In any event, it's likely to show up in 2007 and after the midterm elections...

[a]

I'd generally agree with both Brad *and* Winslow. One should be cautious about explanations why this time it's different. On the other hand, maybe this time *is* different.

My guess is that we will need a much bigger inversion of the curve before recession becomes a slam dunk - and of course, all bets are off if there is at last the long-anticipated run on the dollar.

[reason]

Anne,
I have also noticed that the end of the housing boom, plus energy inflation has not (yet) generated a recession in a number of OECD countries. And that in spite of structural headwinds and a looming demographic crisis.

The policy stance of governments in the various economies seems to be irrelevant. (I am beginning to think that globalisation is really reducing policy effectiveness in all but the largest economies). Stimulate and it mostly flows out the trade balance.

What IS going on out there? I have the feeling that nobody really knows, our models have all failed us. But it could of course be the case that the US has been holding it all up, and that when it falters the rest will come crashing down. I know that the yield curves in both the UK and Australia inverted in (the northern) summer last year. I think we will see recessions in 2006, I'm just not sure when.

[anne]

Reason

A clever important argument. Suppose that Ben Bernanke's observation is correct and that economic flexibility has been increasing in developed economies these last 25 years, and especially the last 10. Possibly even Japan and Germany have developed a flexibility on the order of America. Then, it may be that monetary and fiscal policy can be even more effective.

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Dollars]
12/31/04 - 12/30/05

Australia 17.5
Canada 28.9
Denmark 25.3
France 10.6
Germany 10.5
Hong Kong 8.4
Japan 25.6
Netherlands 14.9
Norway 25.7
Sweden 11.3
Switzerland 17.1
UK 7.4

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Domestic Currency]
12/31/04 - 12/30/05

Australia 25.6
Canada 25.6
Denmark 44.8
France 27.4
Germany 27.4
Hong Kong 8.1
Japan 44.7
Netherlands 32.5
Norway 40.5
Sweden 33.3
Switzerland 35.8
UK 20.1

[Craig Tindale]

John Mauldin has some good points about rates of inversion and probability of follow on recessions

http://www.safehaven.com/article-4363.htm

[anne]

Notice the seeming broad adjustment in equity prices in domestic currencies to the strength of the dollar. The international bull market in stocks last year was especially broad and deep in domestic currencies.

[wkwillis]

Never forget that what is good for the economy as a whole is bad for some parts of it. A dollar collapse recession makes 80% of America better off, and 20% much worse off. Statistically it's a recession, but it will make Bush very popular in retrospect.

[anne]

Another aspect of the international economy that should be noted is the marked decline in volatility in investment markets in the developed economies. Stocks, bonds, real estate and currencies have moved with surprisingly little volatility these last 4 years. Economic shocks have been muted in market effect. Also, economic shocks have been increasingly muted in economic effect for 25 years and especially again these last 10 years.

[J Thomas]

I'm having trouble following this. It isn't my field.

I want to try to apply common sense. This is notoriously unreliable but maybe somebody will clear things up afterward....

First off, as far as a whole lot of americans are concerned, the recession is already here. I look at the forums for my wife's online game. People are quitting because they don't have the money to play, not that many, only 1% a month or so. "I joined the army. I'll be back when I get online access again."

"Thank you Blavgas for paying for my account last month. I found somebody who gave me a place to live and food for sex and I've been using his computer. I keep lookiong for work but it's 30% unemployment here and now my car broke down and it got towed for outdated license and they charge $55 a day to keep it. This game was the only bright spot in my life."

"I don't understand people who don't get work. There are plenty of jobs here in central california, but it's all mexicans and east indians who get them. 40% of my town is on welfare and most of them are on drugs, and they refuse to work. I tell people about jobs and they say they won't work with mexicans. I'm doing fine. I'm in the union."

"Wish me luck everybody, I'm joining the Marines. Every time I lose a fast food job I can get another one in two weeks, but I just got tired of it."

"Anybody can get work. I have a part-time job while I'm in college. If I can do it anybody can do it."

"My roommate left and I had to take a second job to pay the rent. When I get home I'm too tired to play so the $12.95 isn't worth it. I'll miss you all."

If this isn't recession, a lot of us are going to hurt bad when the real recession gets here.

Inflation -- This time last year rump roast from the SFW was $3.99 a pound. This year it's $4.60. Last year most of the bread was around $1.60 a pound, and the discount house brand was 65 cents. This year most of the bread is at $2.10 a pound and the discounted bread is 88 cents. Last year the dried beans were around 67 cents a pound, except for lentils and split peas which were around 48 cents. This year the dried beans are 89 cents and the lentils are 65. If you're poor enough that the cost of food matters, inflation is already here. The bright spot might be rent, but I hear that from statistics, I haven't actually checked rents for comparable properties. My guess is that the better places -- rented condos and such == 1got put up for sale, so the remaining part of the rental property market is the worse part, and rent increases might get lost in that. I dunno.

People who're buying bonds are wondering when the recession will hit the bond market, because they do better if they can predict the precise time. Is that what this discussion is about? Apart from the precise timing, is there any doubt that it's coming? Does the economy depend on US consumer demand? The US public is tapped out, except for the sort of people who buy bonds....

So somebody's willing to pay more for long-term bonds than for short-term bonds. And the first question is whether they mind losing money. If we can assume they don't want to lose money then this tells us something about what they think will happen. Nobody wants to lose money except central banks, who might have other concerns. Their prime other concern is to keep enough dollars to ensure liquidity. But would any central bank have a problem getting enough US dollars? By sheer common sense that sounds absurd. They have more trouble finding some place to park dollars. So unless there's some other reason for central banks to lose money holding dollars, we can assume that everybody in the bond market wants to make money and not lose it.

Everybody who buys longterm bonds is betting that the US dollar won't inflate much. If they don't want to make that bet they should trade their dollars now for some currency they think will deflate less. But how can anybody think the US dollar won't inflate a lot? How can it not? What can we offer for our dollars? Well, we produce 40% of our own oil. If we were to cut our oil consumption by 80% then we could export 20% of our current consumption.... We could sell hi-tech weapons if we had a prosperous buyer that we trusted.... I just don't see it. We're importing more than we export, we're consuming more than we produce, we're paying the difference in dollars that don't get taxed, how can we not get inflation?

OK, how about this. Say you're a rich american citizen, and you expect there are going to be extortionate taxes coming. And you think you can avoid extortionate taxes on government bonds. Then it could be a tax shelter. Even if you lose 30% to inflation that's better than losing 80% to taxes. But if you think that way, why not move your money out of the country and go to Monaco etc yourself?

OK, the people who're buying bonds are the ones who're the most optimistic about bonds. They quite reasonably don't want to put their money in the US stock market. On average results have been lackluster, and they might have been tracking the investigations into NYSE corruption. *All* the specialist companies have paid whopping fines for getting caught? And if you don't trust american stock exchanges which foreign ones would you trust?

Suppose you were pessimistic about longterm bonds. What would you do? Is there a way to sell long and bring the price down? Or would you just put your money somewhere else? Could it be there are just some people who're optimistic about longterm bonds, and the Treasury miscalculated slightly and released slightly too few such bonds for the optimists? They don't want to release too many of them and have trouble selling them. Could it just be a little glitch on their part?

[J Thomas]

Sorry, I was distracted, I meant sell short instead of sell long.

[nate]

http://bigpicture.typepad.com/comments/2006/01/a_world_of_most.html

"2) Foreign buying of US bonds cannot explain flattening yield curves elsewhere (See chart above);"

per this posting at DeLong blog:
"This inversion of the yield curve, however, is generated not by domestic investors' thinking that a recession is on the way, but by foreign central banks' desires to keep buying lots of dollar-denominated bonds in order to keep their currencies from appreciating."

comment:
what gives? are these two quotes somewhat inconsistent?

[Chris Dalton]

Nothing lasts forever and neither will an inverted yield curve. I am buying assets that will do well as it reverses. Namely FBR.