The Treasury Normal Yield Curve: The Fed Operates On The Curve Routinely But It Has Been The Conundrum To The Markets

by: O. Young Kwon


•The Treasury yield curve has been a good predictor for coming recession or inflation. The curve rises smoothly or stiffly or is relatively flat or inverted.

•The Fed can utilize its stock of all maturities through Open Market Operations (OMOs) and Permanent Open Market Operations (POMOs),

.•The Fed and the Treasury Department together can control the shape of the yield curve either to stimulate or to cool down the economy.

•The policy implications of this policy mix are broad and profound:

Bond yields and security prices are observed directly from the financial markets, and probably reflect fairly all wisdoms of market participants. This is the main factor that can distinguish these market data from most other economic indicators that are compiled by a government agent of private institution.

The yield curve which is a chart plotted ten yields, covering the entire spectrum of maturities on U.S. Treasury securities (1-, 3-, 6-month bill, 1-year bill, 2-, 3-, 5-, 7-year note, 10 year note/bond, and 30-year note.) They start on the left with the shortest maturities and then progress to all way up to 30 years bond at the right side.

There are four patterns of curves - normal, stiff, flat, and inverted. In a normal time, investors demand a higher "term premium" on a longer-term Treasury. The term premium is the excess yield needed to compensate for the risk of buying one longer term bond rather than a number of shorter-term bonds. Therefore a normal curve rises as the duration lengthens.

A stiff curve is an extreme shape to rise the yield more rapidly, anticipating higher inflation or a selloff of higher-term bonds by investors or central banks. A flat curve shows a relatively even yield on the various durations. This normally warns a problem in economy in the near future. Finally, an inverted curve that is a shorter-term bond has higher yield than a loner-term one. It indicates an imminent danger into a recession or a spike of inflation.

On Feb. 12, 2016 (Friday) the yield curve was normal. The 30-year yield was 2.065% (and the 10-year yield was 1.748%) so that the difference between the 30-year yield and the one-month yield was about 2.5%. A 2.5% is the normal spread on the yield curve.

On Feb. 9, 2016 (Tuesday), however, The Wall Street Journal reported that a "small part of the yield curve inverted," but by Feb.10, 2016 (Wednesday), "the spread was back to normal, with the six-month note trading at 0.461% and the one-year yield at 0.536%, according to Tradeweb" as shown in the following chart.

The Source: WSJ(

An inverted curve warns a danger in the future, but the above case is just partial and for a couple of sessions. The inversion was corrected when the one-year Treasury was sold by investors, and then the yield curve became normalized. If the inverted curve for all duration happens and a correction is not made, investors concern about economic weakness or higher inflation.

The inverted yield curve has not had headlines in the recent years. What happens on the yield curve? Why is the yield curve so steady even though the markets keep repeating numerous routs every week recently? The right answer is the fed is doing corrections whenever the Treasury market fail to do itself. How? Most investors think that the Fed is just raising interest rates. The Fed now has no policy tool to boost the economy and the markets. The truth is the opposite.

The exit strategies of the Fed's ultra-easy-money policy to fight the global financial crisis and the great recession have been designed from the beginning until now and further, perhaps for more than a couple of decades. The huge volume of Treasuries for all durations on the Fed's balance sheet is the source of the Fed's powerful and efficient operations to maintain a "desired" yield curve at any time. Why does the Fed do this? Because a steady and "right" yield curve is the solid ground for sound economic activities of banks, financial firms, consumers, and businesses.

In his informative indicator book, Bernard Baumohl noted a puzzling incident of the yield curve in the mid 2000s:

"Clearly, the yield curve has had an enviable track record of predicting turning points in the economy. But…{t}he yield curve had been inverted in both 2005 and 2006, yet the economy showed no sign of slipping into recession.. Even more puzzling was that this inversion occurred against a backdrop of economic vitality, rising inflation, and higher short-term rates. Normally yields on longer-term Treasuries would jump on such occasions to produce a positively sloped curve. But that didn''t happen. Instead, the curve inverted, with long-term rates remain below those of much shorter maturities. This perverse behavior in the yield curve has bewildered many experts, including…Alan Greenspan who characterized.. as a 'conundrum.'" (The Secrets of Economic Indicators, 2008)

There were four reasons for the conundrum: First, the demand for U.S. Treasuries has been changed fundamentally since the 2000s. Treasury investors in America and abroad buy the U.S. Treasuries without seriously considering the economic conditions of the U.S. They simply need them to build their portfolios with other financial assets.

Second, export-driven countries (China Germany, South Korea, and Japan) and Oil-exporting countries (Saudi Arabia and Russia) purchased Treasuries with their trade-surplus dollars and their oil money, respectively. In particular, South Korea made an extra effort to increase the dollar reserves after the financial crisis in the late 1990s.

Third, the retirement of U.S. baby boomers started. It affects overall consumption level and Treasury demand for their retirement portfolios. The propensity to consumption of the retiree is lower than the younger, and the former allocate more Treasuries than the latter in their portfolios, resulting lower spending (and economic growth) and inflation.

Lastly, there is irony in the conundrum. The Fed really succeeded taming inflation through the leaderships of Volcker, Greenspan, and Bernanke. This is no doubt a welcome part. The other somewhat less welcome part is Treasuries become much popular for investors as a very low-risk investment vehicle. Investors believe that inflation would be very low in a long haul.

The former Fed Chairman, Ben S. Bernanke, adopted the inflation targeting and explains how it helps monetary policy more effective:

"Inflation targeting would improve U.S. monetary policy. For one, setting a permanent inflation target would create an institutional commitment to continuing the Volcker and Greenspan policies that had lowered and stabilized inflation, while producing two long economic expansions during the 1980s and 1990s. Just as important, from our perspective, the increased transparency that accompanies inflation targeting would, by shaping market expectations of the path of future interest rates, help the Fed to better achieve its objectives. In contrast, less transparent policies would keep markets guessing unnecessarily…[I]f the public expectations of inflation are 'well-anchored' at the target - then the demands of wage- and price-setters will tend to be moderate. Moderate wage and price demands would in turn allow the Fed to fight rising unemployment aggressively with less concern that inflation might get out of control." (The Courage To Act: A Memoir Of A Crisis And Its Aftermath, W.W. Norton, 2015, pp. 39-74)

No other indicator or measurement has revealed as much accurate prediction in warning of upcoming turning points in business cycles and inflation movements. Since 1960, all six U.S. recessions have been preceded by an inverted yield curve for months ahead.

The yields of Treasuries are determined by the interactions between demand and supply forces in the Treasury primary and secondary markets. In the mid 2000s, the demand schedule of Treasuries was shifted upward by the four factors pointed before - (1) the enhanced demand to build long-term portfolios, (2) the increased demand by the export-dependent and oil-producing countries, (3) The baby boomers' retirement, and (4) the "well-anchored" inflation-expectations' irony. All these factors contribute to flatten the yield curve. The flat curve in turn misled the markets and policy makers..

Now, all factors except the augmented demand for Treasuries (from China, Russia and Saudi Arabia) remain intact. Saudi Arabia, Russia, and China reversed their position, by selling U.S. Treasuries to cover their budget deficits or to manage their currencies. Therefore, the net effect of the four factors would be muted.

All existing Treasuries, no matter what year those were auctioned (i.e., in 1966 or in 2010) or who holds them (i. e., the Fed or Saudi Arabia) are "rolling down" as time passes. For instance, for all practical purposes, 30-year Treasury (issued in 1966) held by Saudi Arabia is 10-year Treasury now. 7-year Treasury (issued in 2011) held by the Fed is 1-year Treasury.

In general, the nearer to maturity a Treasury, the lower its yield. But because prices and yields move in opposite directions, lower yields of shorter Treasuries would gain in prices. Therefore, The Fed can rollover matured Treasuries to any duration of Treasury or to longer-term Treasuries (i. e., 30-year), if needed.

The question is who would be principal player in the Treasury market today. Investors would anticipate another Large-Scale Asset Purchases (LSAP) (or Quantitative Easing), as a "QE4." Some would expect "Janet Put" or another "Taper Tantrum," or possible "Negative Interests." This kind of discussions would be irrelevant for the Fed because the Fed just started to move toward a normalcy from the radical "emergency" policy.

The Fed has an enormous amount of Treasuries of all different durations in its balance sheet. These "stock" of Treasuries is the potent ammunition to be able to dominate in the Treasury market. The Fed would be confident to execute its exit programs which has been developed over many years. In particular, the Fed's leaderships with Yellen and Stanley Fischer (Vice Chairman, the former MIT Professor and President of the Bank of Israel) are conspicuous.

In my 2013 article, I explained how the Fed manages the shape of the yield curve to guide toward its monetary policy goal through its "(Permanent) Open Market Operation":

"In a sense, the current easy-money policies are passive. If the Fed will start exiting (or mopping liquidity) and tightening (or raising interest rates), the Fed policies will become active and more dynamic. The Fed will have Permanent Open Market Operations (POMO) in addition to Open Market Operations (OMO). The OMO is a traditional policy tool. The only difference between OMO and POMO is the former deals over-night lending rates while the latter longer-term government bonds. We experienced POMO with the Operation Twist (or the Maturity Extension Program) in 2011 and 2012. The MET (or OT) is to buy longer-term bonds, by selling shorter-term bonds. The Fed is a seller in the bond markets with this program. As a result, the Fed will be almost everywhere in the whole spectrum of interest rates, ranging from the over-night lending rate and a reverse repurchase program (coming soon) to the longer-term government bond yields." ( The Federal Reserve Doesn't Blink This Time, The Market Does )

What are the policy implications of the new monetary-policy environment equipped with a new tool (POMO) in addition to the traditional OMOs. POMO is a somewhat real-time operation through actually entire session and is a routine operation in the New York Fed. In this sense, POMOs are quite different compared to the previous stimulus programs such as QEs or OTs. As result, The policy implications of the combination of POMOs and OMOs are really broad and profound:

  • First, the Fed is capable to control not only short-term interest rates (or yields of Treasuries) but also longer-term rates (or yields) (with somewhat reduced strength). The Fed would strengthen the longer-term effect through its guidance to investors as it did with inflation targeting before.
  • Second, the shape of the yield curve has more nuances than just being rising or or flat or inverted. In a rising slope, the stiffer the curve is the more accommodative, and vice versa. In an inverted case, the sharper, the curve is the more restrictive, and vise versa. Given a slope, when the slope is concave as shown in recent years it would give more stimulus. In the same token, when convex it would be tighter. This implication is very important because this can be a "shadow" policy which the Fed either boost or cool down the economy with, but the markets even wouldn't notice it.
  • Third, more important, we would see a policy mix of fiscal and monetary policies that has not seen in many years. The main reason for lack of policy mix was that Congress and White House didn't provide short-term eventually deficit-neutral spending programs which could boost the economy during a recession. The Treasury Department and the Fed coordinate to target a right shape of the yield curve: Treasury auctions would be scheduled in a right time for the right maturities while the Fed operates the right combination of the durations of its Treasury holdings.
  • Forth, the "new" monetary policy would become more efficient, more timely, more promptly, more powerfully, and giving far-less disturbances to the financial markets. The Fed and the markets go ahead into the uncharted territory so policy makers and investors must work together by exchanging the positive and constructive feedbacks rather than making some destructive headlines like those surrounding negative interest rates.

Why have the markets routed repeatedly since the last summer, on China, on oil, on high-yield bonds, on emerging-country debts, on the Fed's December rate hike, on the Fed's January inaction, on the Japan's negative interest rates, on the market's guess about Fed's further rate increases, and so on?

The main reason is that the markets and investors would fail to grasp the current monetary policy. We do not have any historical data or previous experience of this kind of policy. Quite contrary to the market perspectives of investors, the current monetary policy would be on the firmer ground with the Fed's well-prepared plans and some unprecedented policy tools.

In 2013, Janet Yellen, expressed her view on the Taper Tantrum as:

"In a March speech, Fed Vice Chairwoman Janet Yellen pointed to showing that it is the amount of 'stock' of bonds the Fed holds that matters for long-term rates, rather than the pace, or flow of purchases…Under the stock view, that should push rates higher. ("Bernanke's Bond-Buying Paradox for Markets" The Wall Street Journal June 20, 2013. page C10. The highlights are mine.)

The Fed didn't make its scheduled rate hikes twice in the last September and in January. It was postponed due to a number of the unexpected negative data: It was a pause not a start of the reverse course that the market would expect. Now, the Fed would resume rate hikes that it penciled one percent this year. If that happens, it would be right way but the markets would roil further in a short run. But in a long run, the policy would help the economy.

The values of the U.S. dollar and other countries' currencies already reflect the Fed's rate schedule this year so that the impact of one percentage increase would not be significantly destructive. Many countries have been prepared in advance, by delaying their rate cut (i.e. the European Central Bank to keep preferable interest differential) or by raising interest rates to minimize capital outflow.

Also, in the recent weeks there have been some favorable signs for abating investors' worries on oil prices, the llow inflation of the U.S., and the U.S. election outcome: (1) A 2.7% GDP growth forecast of the first-quarter GDP of typically cautious Atlanta Fed, (2) The initiative of Saudi Arabia to put a cap on oil productions, (3) the 2.2% annual inflation of the core consumer prices (and 3% of the core service inflation) in the U.S. according to the Labor Department.,and (4) a little bit better chance to get a better result of the election in November..

I don't predict the bond and stock markets. But it's easy to forecast the markets in a few decades or in a few days: in the long run the markets have a strong tendency to regress to the long-run average, and in a near term, they always fluctuate. In the between these two terms, however, it's impossible to predict the future movements of the markets. Therefore, my market perspectives are based on my casual market outlook, based on my analysis and my indicators.

In a couple of months I am bullish, cautiously optimistic until the end of April, neutral between May and October, cautiously bullish from November until the reliable signal of a peak of the current recovery. It's ironical that the current timid recovery lengthens the current upswing. As a result, we would not see a recession signal within two or three years. Then I would expect a garden-variety recession that is not another financial-crisis induced great recession: The coming recession is a traditional recession which would be short (perhaps less than two years). After a recovery would start, I would be bullish for at least 5 years or longer.

It would be a good time to set up your portfolios with the unusually depressed prices of most securities. The best vehicles would be the low-cost index ETFs such as Schwab U.S. Large-Cap ETF (NYSEARCA:SCHX), Vanguard Total Bond Market ETF (NYSEARCA:BND), Schwab Emerging Market ETF (NYSEARCA:SCHE), Power Shares Insured Municipal Bond ETF (NYSEARCA:PZA), Schwab U.S. Dividend Equities ETF (NYSEARCA:SCHD), and Power Shares Financial. Preferred Portfolio. ETF (NYSEARCA:PGF).

Also, if you already have long-term well-diversified portfolios, you would re-balance your assets and their components. If you feel too boring with your long-term portfolio, without trading (and even re-balancing) like me, you may allocate some capital (less than 5%) in a trading account at a discount brokerage. The final advice is to keep some cash at an internet-savings account to cover your living expenses in a bear market to come.

It would be remarkable to see the normal yield curve over longer than a year despite the many major or minor disarrays of the markets. It would be the "new conundrum" to the markets, investors, and businesses, but it would be just not unusual to Janet Yellen and Stanley Fischer who actually would direct the New York Fed to operate on the yield curve intensely..

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please mark several quotes including Janet Yellen's properly. Thanks.