Thursday, October 29, 2009

Boundary Conditions

A reader asked if I think the yield curve will flatten. The answer is yes, I do.

A steeply positive yield curve - as it is now - is the bond market's way of discounting a sharp rebound in the economy; I believe this optimism is unfounded and will soon be proven wrong, leading to a reversal. Sketching the picture in very broad lines, declining consumer spending (70% of GDP) will be the most serious drag on the US economy, due to persistently high and rising unemployment.

Let's look at the curve itself (see chart below).

US Treasury Yield Curve

The next chart shows the spread, or difference, between interest rates for 10-year Treasury bonds and 3-month bills since 1953. Currently the rates are 3.47% and 0.07% respectively, resulting in a spread of 3.40%, or 340 basis points (a basis point is 0.01%). That's very high by historical standards (see chart below, click to enlarge).

Data: FRB St. Louis

Next, I perform a frequency analysis for this spread and produce the following histogram (click to enlarge).


In the last 45 years the spread averaged 139 bp with a standard deviation of 119 bp. Quite obviously, the vast majority of the values are positive (above zero), since inverted yield curves are rare.

The charts above, however, do not tell the whole story because they track the difference in rates without taking into consideration their absolute levels. Because nominal interest rates cannot go below zero, it makes a whole lot of difference if a spread of 340 b.p. is the result of 6.40% minus 3.00% or 3.50% minus 0.10%. These two situations describe completely different economic and financial market conditions, even if the spread is exactly the same. So, we need to look at the spread from another perspective.

  • Let's chart the spread as a ratio of the 10-year bond rate, i.e. take the spread and divide by the 10-year rate at any point in time. This provides a better sense of how wide the spread is in relation to the absolute level of interest rates.
The spread is now 96.5% of the 10-year yield (3.40/3.47= 0.965), i.e. a person by putting his/her money in 3-month bills is giving up almost the entire return possible from a longer-term bond. That's quite extreme and unprecedented in the last 45 years (see chart below, click to enlarge). The average over the same period is 25% and the standard deviation is 22%, i.e. the current ratio is in +3σ plus territory.


In a previous post (Bills And Swaps Indicate Great Optimism) I said that such low rates for Treasury bills (plus other indicators such as forward rate swaps) are the result of the Street's optimism. Speculators think the economy is bouncing back, bringing inflation, higher interest rates and lower bond prices with it. Therefore, they are piling into the shortest possible investments in order to shorten portfolio duration and avoid market value losses.

But, we have now demonstrably approached boundary conditions: T-bill rates are essentially zero, meaning that most speculators are 100% certain of the optimistic scenario. The only thing certain being that there are no certainties, I am more comfortable taking the opposite view, i.e. that the economy will weaken again and that the curve will flatten.
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Addition by special request (Greenie): The 10y-3m spread for 1931-1952.


The spread between 1931 and 1952


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GDP Addendum
Third quarter GDP came in at +3.5% (real, seasonally adjusted, annualized), as usual "higher than expected". Crunching through the full set of numbers we can immediately distill the whole report to the following:
  • Cash for clunkers accounted for 1.7%, i.e. half of the increase.
  • Inventory adjustments (lower liquidation of goods in stock) accounted for another 1%.
In other words, 80% of this "growth": (a) came from a temporary government boost that is already gone (see chart below), or (b) was essentially technical in nature.

25 comments:

Mich said...

I don't believe the speculators are optimistic. Try to think of a pessimistic scenario with the same effect. One involving the collapse of the value of money.

Debra said...

Really interesting post. I don't have the tools to understand all the nuances in it, but I get the gist of it, nevertheless.
And Mich's point is really interesting too. Are them thar speculators really optimistic, have they lost sight of that all important difference between looking at... JUST differences (numbers on paper...) or... taking into account the absolute framework and the stark reality that unemployment is skyrocketing and the economy is still fueled by consumer spending ?
OR... are they reacting like the increasing number of people in the U.S. who do not accept that global warming is a reality fueled by OUR activity on this planet, and that, as a result, we are heading into the wall at 200 mph ?
Hard to tell, right, when you start trying to predict and understand how the HUMANS who are underneath the group label "markets" are going to react, and the reasons for their reactions...
Like... what do "the markets" have in common with that overdepressed guy who goes out into the streets and aggresses a cop to get himself... SHOT ?

Tiago said...

So, when the short term interest rate jumps up, and the USGovt rolls its short term debt, the interest to be payed will jump up quite a bit, I would imagine?

I wonder how many countries are financing most of their debts on very short time-spans and are dependent on existing liquidity? I am thinking Lehman Brothers kind of event, but sovereign style...

Hellasious said...

Mich said:

"I don't believe the speculators are optimistic. Try to think of a pessimistic scenario with the same effect. One involving the collapse of the value of money."

If speculators were seriously concerned about hyperinflation then the long end of the curve would be over 10%. Instead it's less than half that.

Yes, central banks are buying long bonds at the auctions, but the secondary market is so large that it would swamp them - if it wanted to. People would just dump long bonds they already own - and they own lots.

Is the bond market "stupid"? Hardly.. even though the Street is not full of Mensa types (and we have seen the results of Nobel laureates managing money) it is hardly populated by a bunch of idiots.

No, I think long-term fixed income investors (eg PIMCO) are still VERY concerned about the possibility of a long, drawn out period of deflationary pressures, so they are holding on to their positions.

This is creating a two-tier market: one side thinks the economy is rebounding and is buying short paper and another that is far more cautious and is, thus, holding on to their long bonds.

Regards,
H.

Jefferson said...

Hellasious,

Couldn't the steep yield curve also be reflective of growing fears of credit risk given current levels of deficit spending and future entitlement spending obligations?

Hellasious said...

Dear Jefferson,

Right now, the wide spread is not caused by high interest rates on the long end (which could indicate credit risk), but by near zero rates on the short end.

Regards,
H.

Thai said...

Nice Post

Any implication to the fact that 10 year minus 3 month spreads are greater than the rate of growth of our economy right now?

Hellasious said...

dear Thai,

See the addendum...

Anonymous said...

Hell:

As I was reading your post and got to the 10yr/3mth spread chart, I wondered what the ratio was because, the fact is that, that is the picture that tells the story.

And then, VIOLA....! Many thanks....

Econolicious

Thai said...

Thanks and ugghhh...

This is how we want to spend our money!!??

By the way, I loved the boundary condition reference ;-)

I will share one back: enjoy


Regards

Michael said...

Very good post. My opinion is that monitoring the bond market is much more important and profitable than watching stocks. The negative yield curve in 2007 was the single most important piece of information an investor needed to know at that time.

It is amazing that investors just can't fathom lower bond yields. Japan's ten year is about 1.5%. We could go there too. Owning long term treasuries today can be profitable.

Anonymous said...

"A steeply positive yield curve - as it is now - is the bond market's way of discounting a sharp rebound in the economy"



I dont understand this....what are the mechanics behind this ?


if the bond market thinks the economy is getting better, wouldnt people be selling the short term bonds thus raising yields there and flattening the curve ?

confused....

Greenie said...

Hell, Do you have the same chart (difference between long and short bonds) extended to 1920s?

Thank you,
G.

C & C said...

The future is 'deflation in what you OWN, inflation in what you NEED' --especially if it is tied to oil/energy imports and as the dollar is driven down, our energy costs will be driven up while the rest of the world will face less impact.

i agree the curve will flatten, but it will flatten UP on the shorter end to attach all those TRILLIONS the messiah feels entitled to spend.

Hellasious said...

For Greenie:

See the post again, towards the end, before the GDP addendum. I have it going back to 1931.

As my college-days pizza parlor proclaimed.."You ring, we bring"

;)
H.

Anonymous said...

"A steeply positive yield curve - as it is now - is the bond market's way of discounting a sharp rebound in the economy"



I dont understand this....what are the mechanics behind this ?


if the bond market thinks the economy is getting better, wouldnt people be selling the short term bonds thus raising yields there and flattening the curve ?

confused....

Greenie said...

"See the post again, towards the end, before the GDP addendum. I have it going back to 1931."

Thanks H. I see the same number 3.4% at the peak of early 30s. Interesting.

The chart gives some idea about how the spread narrowing can play out.

Hellasious said...

To anonymous abt. short end of the curve

No, it's actually the reverse. For any given increase in interest rates, long bonds change in market price much more than short ones.

Thus, if an investor/speculator thinks rates are going up because the economy is rebounding, he/she will seek to keep the average maturity (or duration) of his/her portfolio as short as possible in order to avoid losses.

One way to do this is to buy very short-term securities (eg bills) to achieve a lower "blended" duration.

Regards,
H.

Thai said...

Hell

re: "The spread is now 96.5% of the 10-year yield (3.40/3.47= 0.965), i.e. a person by putting his/her money in 3-month bills is giving up almost the entire return possible from a longer-term bond."

This statement has tickled my diagnostic curiosity (career curse).

Did the same happen in Japan? (and other nations that have experienced similar credit bubbles in the past)

And if so, do you know if Japanese Treasuries were a superior investment for Japanese investors vs. all other asset classes when this happened? (From the point of view of a Japanese investor)

If Japaneses Treasuries were not the best place for a Japanese investor to park their money- why not?

And if the 10year-3 month widening did not happen in Japan, why not?

There are boundary conditions within boundary conditions...

Would Japan's boundary conditions back then vs. the world's boundary conditions back then look different compared to America's boundary conditions today vs. the world's boundary conditions today?

NOT looking to create work for you with more charts, just curious if you know

Regards

Greenie said...

"And if so, do you know if Japanese Treasuries were a superior investment for Japanese investors vs. all other asset classes when this happened?"

That question is a big ambiguous. A Japanese investor would have done better in 1990 by putting money in US tech stocks, provided he remembered to get out in 2000. On the other hand, if he kept holding, he might not look that good today.

Therefore, what time frame are you talking about?

Debra said...

A little comment on "boundary conditions" from a philosophical standpoint, which also has its importance.
We are seeing, and have been seeing... that while the extremes are inhabited (the boundaries...) the... MIDDLE is disappearing fast.
Middle, like in...
Middle class.
Middle commerce (you can find CHEAP stuff, and EXPENSIVE stuff, but little that is... in between, like for the ... middle class.
While "normality" MAY be the word on everybody's lips (trying to be.. "normal"), in the meantime, the... extremes are filling up quickly..
Makes me think that we are in for ideological upheaval, nontheless.

HomoSarcasticus said...

Once again I have to totally dismiss Debras' enthusiasm about climate change.
Now, there's no doubt that climate is changing on Earth (and on other planets, too), as it has since Day 1, but when you see oil / energy companies, green junkies and pure scumbags like Gore come together to concoct a bogus fairytale, I'm not the one to believe it.
There's a lot humans can do - like developing cleaner production cycles, limiting 'wasteful living' (maybe including some limitations on production of Barbie dolls and similar crap :)), fighting air / water pollution etc - yes, that can be done. But to say that humans are the driver of Global Warming, completely ignoring the SUN, and propagandizing that CO2 is some sort of evil Earth killer?!? Now that reminds me of Russian word 'lohatron' - a gleeful activity involving 1) fools, or lots of fools, 2) relieving them of their posessions. And that's what 'fight against global warming' is - new restrictions and taxes you'll happily pay and never learn how that money was actually spent! :D

OK, sidetrack issue, go on folks.

Thai said...

Greenie 3 to 5 years at most.

Debra said...

Geez, when did I ever say that I was enthusiastic about climate change ???
I said that we are in for ideological upheaval, and I maintain that.
Now... I will remind y'all that... while we are fighting in corners trying to determine IF we are responsible for climate change or not (the REAL issue is... is there a foreign agent, a.. GOD behind all of this who is collectively punishing us for our greed, or... not ? Do we BELIEVE WE could be responsible for this happening or not ?), the earth is... warming up.
So... while we point fingers at each other saying "it's YOUR fault", blahblahblah, the problem is just getting worse, and we should be doing something about it (and not selling permits to pollute either...)
We are going to have to bottom out on filthy lucre for that to happen, I fear. And I can tell that Hell does NOT believe me on this one. Yup, you're right, it does sound a little.. extremist.

fajensen said...

... if an investor/speculator thinks rates are going up ...

He will borrow as much as possible at the longest possible duration and use the proceeds to buy the short bonds with; which is what he will deposit as security for the loan.

IOW: He will be selling the long bonds and buying the short ones.

But ... long rates are not going up as they should do, they are still falling*.

So, IMO, everyone are piling into the short end because they worry more about return OF capital than the return ON capital.

They do not believe in a recovery, inflation or rising rates, they just want the safest "bank" they can possibly get to hold their cash.


*) Who knows actually, maybe the central banks are out buying all the "long end" they can to pull money forward into "now" so they can be spent on any kind of crap that will fix the "growth" stats.

The Danish have set aside DKK 4,000,000,000,000; - four times GDP - aside for the banksters to "save the economy"; with that money they can buy the entire Danish credit market for decades!

Short rates may end up staying low Forever!