Yield Curve Inversions When Expected Inflation is Low

I haven't known what to say about the briefly inverted yield curve because it does not alarm me as much as it does others. I guess the best way to put it is that it is like a noise in the dark. It's not a problem in and of itself, but it may signal trouble. It's something that catches your attention, and it's worth paying attention and checking to see if anything is wrong, but there's no certainty that trouble is near.

I am not worried. I believe there is a fundamental difference today versus recent decades. Up until now, I had no faith that monetary authorities were committed to fighting inflation first and foremost and I never would have dared risk a variable interest rate loan. Experience suggested that eventually inflation would return, or there was at least a substantial chance that it could return. Today I would be willing to bet, even for a decade or more, that inflation will remain in check and I would be willing to sign a variable rate contract to try and win that bet (this is not advice on mortgages as I am abstracting from lots of other differences in terms). Up until a year or so ago, I did not have such faith. But monetary authorities have convinced me they will not waiver in their commitment to price stability.

If I am not alone, if there has been a substantial change in long-run inflationary expectations regarding the risk of higher inflation, that flattens the "natural" yield curve. Due to liquidity concerns, long-term rates should still command a premium so the natural state is upward sloping, but I would argue it is fairly flat.

With a flattened "natural" yield curve, and variation around that natural state, it is more likely that an inversion will occur than in the past. But since the natural state of the yield curve is flatter than in the past, an inversion does not represent as much of a deviation from the natural state as it once did and hence does not bring as much consternation with it, at least from me.

Comments

[anne]

What is interesting is how sweeping and deep the bull market is internationally the year, but American large cap stocks are little included. Long term bonds are actually bettering the return on the S&P for the year. These last 6 years have marked the greatest difference between returns to bonds and stocks, in favor of bonds, since the Depression.

The favorable level of long term interest rates rather tells me that investors think inflation will be dampened over the coming years, and I find little to fret about in this.

[anne]

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

National Index Returns [Dollars]
12/31/04 - 12/27/05

Australia 15.6
Canada 28.0
Denmark 25.8
France 12.4
Germany 11.9
Hong Kong 9.7
Japan 25.7
Netherlands 16.6
Norway 25.1
Sweden 11.4
Switzerland 17.0
UK 7.9

[anne]

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

National Index Returns [Domestic Currency]
12/31/04 - 12/27/05

Australia 24.7
Canada 25.3
Denmark 44.6
France 28.8
Germany 28.2
Hong Kong 9.4
Japan 43.6
Netherlands 33.6
Norway 39.5
Sweden 33.6
Switzerland 35.1
UK 19.6

[nate]

it is interesting that people are willing to pay so much for long-term U.S. bonds that pay such little interest, or even possibly less interest than short-term bonds.

maybe people are currently paying too much for long-term bonds.

[ilsm]

In 1985 I bet interest rates would fall, I took a one year ARM. I was very lucky it occurred. Closed it when I sold the place, it had a lower interest rate.

I think the issue is: how can any price level rise if the current bubble in housing, long term bonds and equities, like the irrational exuberance one, busts?

[anne]

The preferred question to ask may be whether we would settle for a return of 4.4% over the coming 10 years, which is what the rate is now on the long term Treasury. There is not much chance of a capital gain. Evidently a lot of professional or institutional investors are willing to settle for the secure 4.4% income stream in dollars, though I would not be.

However, notice, how robust international equity investments have been and how well international real estate is holding.

[Winslow R.]

"I haven't known what to say about the briefly inverted yield curve because it does not alarm me as much as it does others."

A 'brief' inversion is not alarming especially 2 and 5 years with the 10 year. The FF rate is the inversion that matters.

"It's something that catches your attention, and it's worth paying attention and checking to see if anything is wrong, but there's no certainty that trouble is near. "

An inversion causes financial intermediators to lose money to the Fed. If the stock market falls, I'd start to be concerned as intermediators start to liquidate stock holdings to cover loan losses.

"But since the natural state of the yield curve is flatter than in the past, an inversion does not represent as much of a deviation from the natural state as it once did and hence does not bring as much consternation with it, at least from me."

Since lenders borrowed at 1% FF and are now paying 4.25% FF and have loaned out long-term at 3.25 to 4.75% they might be a bit more concerned especially if they wound this trade 50 times by using their long-term loans as security for additional short-term loans.

As to inflation, gold is telling a different story though it's not one that many economists seem to want to listen to.

[anne]

Though, given conceit, I may play in investing, the suggested portfolio of David Swensen is quite interesting. Swensen is the manager of Yale's portfolio, and a brilliant institutional investor, and from what I can tell an awfully nice person :)

Swensen's permanent private portfolio would be Vanguard:

30% American total stock market index
15% International stock market index
5% Emerging markets index
20% Real estate investment trust index
30% Bond market index

The returns to American investors these last 25 years are a terrible shame, with investors continually giving a stunning share of gains to financial service companies. Somehow, other than Swensen and John Bogle, the subject is seldom touched on but I can suggest "Unconventional Success" by Swensen very highly.

[dryfly]

As to inflation, gold is telling a different story though it's not one that many economists seem to want to listen to.

I don't think the gold story is an 'economic' one... I think it is a political one.

With oil still around $60/bbl... Iraq looking just as unstable as ever (Kurds making noise around Kirkuk) & the US losing patience... with all that oil between Saudi Arabia & Iran in play by both... a long disruptive proxy war looks almost inevitable.

My guess is if you were able to look around and count who bought what... you'd see a whole lot of the gold being bought up by foreigners who are more closely tuned into this struggle...

I certainly don't believe gold is moving up because Ma & Pa Kettle back in Kansas decided to move out of CDs into gold over fears of 'inflation'... I think this is a classic 'security move'.

JMHO.

[anne]

The precious metals market was the weakest of all significant market sectors from 1980 ro 2000, though the market is quite small and can move strikingly for speculative reasons. Precious metals stocks were selling at terrific valuations in 2000, and our only now after 5 excellent years caught up with the broader market valuations. I am alwyas careful not to think I know more about market moves than I really do, which is little indeed, but I can know a little more about relative value :) Precious metals stocks though do have short term defensive characterists, but for 20 years short term was the point to emphasize.

[Winslow R.]

"The precious metals market was the weakest of all significant market sectors from 1980 ro 2000

A period of falling inflation...

[calmo]

It seems to me that other countries currently have inverted yield curves (AU) and their sky is still blue and aloft.
But I am intrigued by the financial side, the hedge funds and the new hostile climate of near zero interest rate gradients. To make the same profits, the notional amounts of your bets will have to be leveraged just that much more.
It seems like slim to no pickins for a sizable and powerful component of the economy. So I expect the flat or inverted yield curve to be short-lived.

[Michael Carroll]

I wonder if new-found complacency about inflation does not present a form of moral hazard?

[nate]

This posting on indifference to inversion of yield-curve does not sound inconsistent or does not contradict the WSJ edit-board (op-ed)?

see excerpt:

http://simurl.com/lilnoj