What the Shape of the Yield Curve Is Telling Us

by: David Merkel, CFA

There are many things that are unusual about the current Treasury yield curve. I’ve built a moderately-sized model to analyze the shape of the curve, and what it might tell us about the state of the economy, and perhaps, future movements of the yield curve. My model uses the smoothed data from the Federal Reserve H15 series, which dates as far back as 1962, though some series, like the 30-year, date back to 1977, and have an interruption from 2002-2005, after the 30-year ceased to be issued for a time.

So, what’s unusual about the current yield curve?

  1. The slope of six months to three months (19 bp) is very inverted — a first percentile phenomenon.
  2. The slope of two years to three months (38 bp) is very inverted — a third percentile phenomenon.
  3. The slope of seven years to ten years is steep (57 bp - 5 bp away from the record wide) — a 100th percentile phenomenon.
  4. The slope of five years to thirty years is steep (186 bp - 30 bp away from the record wide) — a 100th percentile phenomenon.
  5. The slope of two years to thirty years is steep (274 bp - 97 bp away from the record wide) — a 97th percentile phenomenon.
  6. The slope of ten years to thirty years is steep (82 bp - 29 bp away from the record wide) — a 98th percentile phenomenon.
  7. The butterfly of three months to two years to thirty years is at the record wide (312 bp). (Sum of #5 and #2. Buy 3 months and 30-years, and double sell 2-years? Lots of positive carry, but the 30-year yield could steepen further versus the rest of the curve, and its price volatility is much higher than the shorter bonds.)

What prior yield curves is the current yield curve shaped like?

  • 9/7/1993 — after the end of the 1990-1992 easing cycle to rescue the banks from their commercial real estate loans.
  • 2/15/1996 — after the end of a minor easing cycle, recovering from the 1994 “annus horribilis” for bonds.
  • 9/14/2001 — 60% through the massive easing cycle where Greenspan overshot Fed policy in an effort to reliquefy the economy, particularly industrial companies that were in trouble. Also days after 9/11, when the Fed promised whatever liquidity the market might need to stave off the crisis.

Okay, I’ve set the stage. What conclusions might we draw from the current shape of the yield curve?

  1. The curve is forecasting a 2% Fed funds rate in 2008.
  2. Fed policy is adequate at present to reliquefy the economy; the Fed doesn’t need to ease more, but it will anyway. Political pressure will make that inevitable. (If we really want an independent central bank, let’s eliminate the pressure oversight that Congress has over the Fed. Better, let’s go back to a gold standard; a truly private monetary policy. Oh, wait. I’m behind the times. We don’t want an independent central bank. Dos that mean we can now blame Congress for monetary policy errors?)
  3. We could see a record slope for the yield curve (in the post Bretton Woods era) if the Fed persists in its easing policies.
  4. One can sell sevens and buy tens, dollar-duration-weighted and have positive carry. Assuming one can hold onto the position, it would be hard to lose at these levels, if the last thirty years of history is an adequate guide to the full range of possibilities.
  5. The Fed is planting the seeds of its next tightening cycle now. Every cut from here will make the tightening cycle that much more intense.
  6. The curve can get steeper from here, but it is getting close to the boundaries where strange things begin to happen. The Fed is not omnipotent, and the steepening curve is evidence of that.
  7. As I have said before, recently, the US Dollar is no longer a “sell” for now. The anticipation of Fed funds cuts is already factored in, and even if we get down to 2%, I suspect that we can’t go much lower because of negative real interest rates and rising inflation.

That’s where I stand for now. The Fed is trying to rescue the economy from asset deflation, much like 1990-1992, but will run into the buzzsaw of price inflation, and tighten a la 1994. Conditions in the real economy are not as weak today as they were in 2001, but the banks are in worse shape. That will drive further loosening by the Fed, until inflation is intolerable.