Bernanke's Yield Curve Confusions
In his speech on March 20, the new Fed Chairman Ben Bernanke admitted that he is not so sure whether the Fed should be tightening its stance further or whether the central bank should pause. The reason for the uncertainty, according to Bernanke, is the unusual behavior of long-term interest rates. Notwithstanding Bernanke's view, the currently observed flattening or near inversion of the yield curve is an indication of a tighter Fed stance that is likely to undermine various activities that sprang–up on the back of the previous easy monetary policy. In short, a flattening or the inversion of the yield curve is likely to result in an economic slowdown. FULL ARTICLE
Comments (14)
Paul Edwards
“But is it possible to have a sustained downward sloping yield curve? One can show that in a risk-free environment, neither an upward nor a downward sloping yield curve can be sustainable.
“An upward sloping curve will provoke an arbitrage movement from short maturities to long maturities. This will lift short-term interest rates [via reduced demand for and hence lower prices for short-term bonds] and lower long-term interest rates [via increased demand for and hence higher prices for long-term bonds], i.e., leading towards a uniform interest rate throughout the term structure. Arbitrage will also prevent the sustainability of an inverted yield curve by shifting funds from long maturities to short maturities thereby flattening the curve...�
As usual, Frank Shostak nails it!
“An easy monetary stance prompts investors to borrow money at lower short-term interest rates [thereby essentially increasing the supply of short term bonds] and invest in higher yielding longer-term investments [thereby increasing demand for longer-term bonds]. This in turn puts upward pressure on short-term rates [by reducing short-term bond prices] and downward pressure on long-term rates [by increasing long-term bond prices]. To sustain the positive-sloping curve the Fed must persist with its easy stance.�
In other words, to maintain low short-term interest rates, the Fed must persist with its inflation; it must persist in pumping new reserves into the economy regularly. Otherwise, market arbitrage will bring short term interest rates up, long term interest rates down, until the yield curves are almost flat.
Great article!
Published: March 28, 2006 5:31 PM
ns
Nice article, but the theory is incomplete. It may be applicable to the yields of up to a few years, but look at the long rates:
March 2006
Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
03/01/06 4.45 4.60 4.75 4.74 4.71 4.68 4.63 4.60 4.59 4.74 4.56
...
03/27/06 4.66 4.63 4.80 4.77 4.72 4.69 4.69 4.69 4.70 4.91 4.73
03/28/06 4.71 4.65 4.83 4.82 4.81 4.79 4.79 4.79 4.79 4.98 4.80
The last 3 numbers are the most interesting:
10-yr yield = 4.79
20-yr yield = 4.98
30-yr yield = 4.80
Such a huge discrepancy would mean, according to the article's logic, that either
- arbitrage does not work (why???)
or
- the traders have ability to predict risks 20+ years into the future
Published: March 28, 2006 6:10 PM
Paul Edwards
I'll take a whack at it, ns:
The thirty year rate appears to be consistently odd and inexplicable. However, the difference in time between a 10 year and 20 year term is a factor of two, and also in absolute time, it is 10 years. Both facts suggest that there is a notable difference purely in the risk factor between these two terms. Therefore, it seems reasonable that this risk differential alone explains the difference and arbitrage is not an issue, but rather there is a greater distinction of product at this point.
Published: March 28, 2006 6:39 PM
Frank Shostak
Hi NS,
many thanks for the interesting comment. I suspect that the 20years are not as liquid as the 10 and the 30 so it could be that the transaction cost on the 20 might be much higher. I am just speculating. Now, as far as theory is concerned the aim is to explain the essence not every point.
All the best,
Frank Shostak
Published: March 28, 2006 7:24 PM
banker
Arbitraging interest rates is very easy if you have sufficient size. Using the interest rate swap market an investor can arbitrage any two rates between 3 months to 30 years. And the cost of doing this is virtually nothing since swaps are leveraged positions requiring no up front investment. Hence, free money.
Published: March 28, 2006 10:42 PM
banker2
For anyone who is familiar with fixed income markets, rates have been so pathetically low that investors have been willing to invest in extremely complicated credit derivatives. Banks love this because they get higher fees, but the investor is the one who suffers because they have to bear so much risk for so little money.
Published: March 28, 2006 10:45 PM
Peter Reilly
I'm just writing to let all punters around the world know that Frank Shostak is the best.
Forget about Keynes, Marx, Greenspan, Freidman and the Chicago School;--- Bring on the Shostakian Thoery of Economic Freedom.
Frank Shostak, for 20 years that I have been following him has called it right all the time. By understanding this blokes thinking and thoeries you will always have a feed on the table, roof over your head and shirt on your back. Go back to your basic high school text book on economics and you will find food, clothing and shelter is all that is needed - anything else is a bonus.
Shostak sees through the fog that is constantly thrown up as diversions everywhere around the globe by thugs,enforcers and overlords trying to get or give something for nothing.
Who needs central bankers and their policies that distort and create misleading values of property.
Published: March 29, 2006 5:39 AM
Yancey Ward
ns,
The fact that the 30 year bond had been discontinued for a while may explain it's lower yield in some way. As for the 10 and 20 (is there a 20 year government bond?), it may be that those yields are affected in some way by the identity of the most common purchasers, who, for various reasons, may not be the same.
Published: March 29, 2006 10:35 AM
ns
To all:
thank you for the responses, it seems to me now this 20yr yield spike is just an anomaly, having something to do with the 30yr reintroduction.
---
Q to the Banker:
Suppose I would like to try to take advantage of this situation, and:
short 1x 30yr Ts
short 3x 10yr Ts
buy 3x 20yr Ts
what's my roundtrip costs and the max available leverage?
Published: March 29, 2006 3:58 PM
banker
Leverage depends on your credit worthiness. Shorting involves repo trades, which are expensive. All of this is assuming you are an investment firm or wealthy individual. However, kinks like this are normal in bond markets and sometimes the spread is too thin to arbitrage away.
Investors mostly use interest rate swaps for curve bets like this unless you are investing against a benchmark. These markets are much more liquid and the curve is less symptomatic to technical issues like the treasury issuing 30 yr bonds again.
Published: March 29, 2006 4:20 PM
ns
Banker,
Is there some trick to borrow at the T-rates directly?
For ex, can I short a bunch of them using a house as a collateral, and use the proceeds to pay off existing mortgage?
Published: March 30, 2006 12:08 PM
banker
If you must short, using bond futures would be the best way. I am not sure how hard it would be for an individual to use bond futures, but that seems to be the only practical way to do that. For that, though, you need a certain networth and income.
Published: March 30, 2006 12:46 PM
ns
Banker,
I'm very interested to chat with you about futures, though I'm not sure it belongs to this blog.
Could you drop an email to nstep2005@hotmail.com ?
Thanks!
Published: March 30, 2006 3:38 PM
Mark Humphrey
What I find especially interesting about Shostak's article is his sense that the slowdown in AMS anticipates a soft spot in the economy ahead. The Fed has been choking back money growth (at least in narrow transactions-based money) while hiking rates, for two years now. Today's news that inflation in the 4th Q perked up to a "core" rate of 2.4% suggests that the rate hiking may extend longer than most expect.
At some point, investment prices are going to take a tumble--stocks, gold, and bonds. At that time, of course, the Fed will do in earnest what they get paid for: wrecking our money. The rude question, as always, remains: might events cascade out of control on the downside?
Published: March 31, 2006 12:56 AM