Now that we're armed with a basic understanding of bonds and the various Treasury debt maturities, let's talk about the yield curve. (In case you missed the primer on bonds, it's here: https://theeconomiccurmudgeon.blogspot.com/2023/05/bonds-yield-curve-and-recession.html) First, let's recap the Treasury maturities:
- 1-month Treasury bill, or T-bill
- 3-month T-bill
- 6-month T-bill
- 1-year T-bill
- 2-year Treasury note
- 3-year note
- 5-year note
- 10-year note
- 20-year bond
- 30-year bond
If we were to graph the yields on those maturities, with time to maturity on the horizontal, or x, axis, and yield on the vertical, or y axis, we'd have a picture of what we call the yield curve. Since the intervals between the times to maturity aren't uniform (e.g., there's only a two-month gap between one and three months, but there's a 10-year gap between 20 and 30 years), the graph is typically represented with the points in between those maturities interpolated step-wise, to illustrate what the yields would be on, say, an outstanding bond with a remaining maturity of 14 years. Don't get hung up on that point; just look at the illustration below.
Since yields change daily (actually, they change throughout the trading day), any graph of the yield curve will be as of a specific point in time. Here's a graph of the Treasury yield curve using closing yields (as of the end of the trading day) on April 1, 2021:
Note that the lowest yield on the curve is the yield on the one-month T-bill, and the highest yield is the yield on the 30-year bond. This is typically the case: short-term yields are generally lower than long-term yields. (We'll discuss why momentarily.) This is what we'd call a "normal" yield curve - it's upward-sloping, left to right, or short-term to long-term.
So why are short-term yields lower than long-term yields? This is referred to as "the term structure of interest rates," or "the term structure of yields." There are three theories that explain the term structure. They're all valid; each plays a role. Let's address them in turn. (Note to my finance geek friends: I realize that the term structure generally refers to the spot and forward curves, rather than the coupon curve; I'm over-simplifying here for the lay reader. I'm not going to get into spot, forward, or swap curves.)
Liquidity Preference Theory
This theory is perhaps the most intuitive. If you have a regular savings account, you can withdraw your money at any time, without penalty. If you want to withdraw funds from your savings account tomorrow, you can do so; if you want to park it there indefinitely, you can do that, too. If you need the money seven weeks from now, you just withdraw the money from your account.
On the other hand, if you have a certificate of deposit (CD), it has a fixed maturity date, like a bond. (As with bonds, there are structured CDs, like callable CDs, but we won't get into that.) If you leave the money deposited in the CD until that maturity date, you'll earn the stated interest rate. But if you try to withdraw it early, you'll pay a penalty, effectively reducing your interest.
Now, why on earth would you tie up your money, let's say for a year, in a CD, when you could just deposit it in a regular savings account and have access to it whenever you want?
If your answer is that you'd earn a higher rate of interest for putting the money in the CD, go to the head of the class - that's the full-credit answer. And you'd expect a higher rate on a five-year CD than on a one-year CD, right? Because you wouldn't have access to the money for five years, vs. being able to withdraw it in a year. The reason you might prefer the one-year CD is that you're not sure whether you'll need the money a year from now, and you're not confident you won't need it for the next five years.
(Another reason might be that you're not sure what rates will be a year from now, and you don't want to tie up your money for five years in case rates are higher in a year, at which time you could take the funds from the maturing one-year CD and deposit them in an account earning even higher interest, but that gets into another theory of the term structure.)
According to bankrate.com, current rates on regular savings accounts range from as low as 0.01% to more than 4.00% for some online banks, but most local brick-and-mortar institutions are going to offer less than 1% currently on regular savings accounts.
One-year CD rates, again per bankrate.com, currently range from 4.75% to 5.10%. This validates the concept that the bank will pay you a higher rate of interest to let them use your money for a full year, without the risk that you'll withdraw it unexpectedly, than they'll pay you for money that you can withdraw at your discretion.
The same concept applies to the term structure of interest rates. The theory is that investors prefer liquidity, meaning they'd rather have access to their funds sooner than later. Except instead of "lending" money to a bank, the investor is "lending" money to the U.S. Treasury. So under normal conditions, we as investors expect a higher rate of interest if we're buying a 2-year Treasury note than if we bought a 3-month T-bill; in the former instance, we don't get our principal back for two years, while in the latter, we have access to our funds in three months. (We could sell the 2-year note in three months, but it might be worth less than par, depending on market yields and thus bond prices in three months - the only way we can be certain we're going to get par at redemption is to hold the note to maturity.)
Likewise, we expect a higher rate of interest on a 5-year note than on a 2-year note; an even higher rate on a 10-year note; and even higher rates on a 20-year or 30-year bond, respectively. Thus, the lowest rates will be paid on those Treasury instruments with the shortest maturities (providing us with the greatest liquidity), and the highest rates will be paid on the longest (least liquid) maturities. We're talking about liquidity here in terms of return of par value at maturity, not how easy it is to sell Treasuries. Also, note that this is a theory; it's generally true, under normal conditions, and that's why a "normal" yield curve is upward-sloping.
In summary, investors have a preference for liquidity, and are willing to accept lower yields for greater liquidity (shorter maturities), but expect higher yields for less liquidity (longer maturities). That preference plays a role in determining the term structure of interest rates.
Market Segmentation Theory
If you have a basic understanding of economics, you know that the laws of supply and demand are immutable. And the greater the demand for something, the higher the price is likely to be. (Technically, I should say the greater the quantity demanded, but let's not get technical. I'm just making the distinction in case there are any budding economists reading this.)
And, as we've established, the higher the price of a bond, the lower its yield. So, the greater the quantity demanded of a given maturity, the lower the yield is likely to be, because the price will increase as the quantity demanded goes up. (Again, this is under normal conditions.) And the less the quantity demanded of a given maturity, the higher the yield is likely to be, because lower demand puts less upward pressure on prices. Looking at that last point another way, if there's less demand for a given maturity, the issuer may have to pay a higher rate of interest to get investors to purchase bonds of that maturity.
Short-term Treasury bills are used by corporations as cash management instruments. There are thousands of U.S. corporations. (Global companies buy U.S. Treasuries, too.) And many of those corporations are massive: the largest U.S. company by market capitalization is Apple, with more than $2.7 trillion in market cap. (Market cap is the value of a company's stock price times the number of shares outstanding.) So if you add up all the companies in the U.S. (actually, the world), and consider the fact that they all have demand for short-term T-bills, it's pretty easy to figure out that the demand for T-bills is going to be massive. Thus, the yield on T-bills is going to be low.
Banks and credit unions tend to invest in Treasury notes, generally in the two- to five-year maturity range. As noted in a previous post, there are more than 4,000 banks in the U.S. and about the same number of credit unions. The total assets of all those institutions combined is about $25 trillion. So there's a lot of demand for medium-term T-notes as well, but not as much as for T-bills. So the yield on those notes is going to be higher than the yield on T-bills.
(Certain insurance companies, like property insurers, also invest in intermediate term notes. Those companies account for about another trillion dollars in size. Also, a number of corporations invest in intermediate maturities as well.)
Life insurance companies generally invest in long-term bonds, because their liabilities are long-term. (A life insurance company's liabilities are the policy amounts they have to pay out when a policyholder dies, so in the case of your life insurance company, you'd better hope their liabilities are long-term.) There are less than 750 life insurance companies in the U.S. The face amount of total life insurance in force is about $20 trillion.
The market segmentation theory holds that there's much greater demand for short-term T-bills, not because of liquidity preference but because of the types of investors that buy them. There's less demand for medium-term notes, and there's even less demand for long-term bonds. Thus, since the highest demand => the highest price => the lowest yield, and so on, yields on T-bills will be lowest, yields on medium-term notes will be higher, and yields on long-term bonds will be the highest, because there are fewer investors in that segment.
(Sidebar: in case you're curious about why banks and property insurers buy medium-term notes, it's similar to the reason that life insurance companies buy long-term bonds: they're matching the average maturity of their liabilities.)
Expectations Theory
The expectations theory is the biggest driver of the term structure of interest rates. It holds that long-term rates are based on expectations of where short-term rates will be in the future. (Note: just as I'm using the terms "bonds" and "notes" somewhat interchangeably, I'm doing the same with "rates" and "yields." My finance geek friends are no doubt grinding their teeth at this; however, if they'd ever worked on a bond trading desk, they'd hear those terms interchanged pretty regularly.)
Let's explain why this is true. Let's say I'm considering buying a ten-year bond. I should be indifferent between buying the ten-year T-note, or buying a one-year T-bill and rolling it over at maturity nine times, for ten years in total. Otherwise, I could execute an arbitrage trade (don't get hung up on that term; it basically just means taking advantage of market inefficiencies). If I'm better off buying the ten-year than rolling the one-year, I could buy the ten-year, sell the one-year short and roll that trade, and pocket the profit. If I'm better off buying and rolling the one-year, I could do the converse. Since we assume that the bond market is efficient and such arbitrage opportunities don't generally exist, we make the assumption that investors are indifferent between buying the ten-year, and buying and rolling the one-year.
If that's the case, then the ten-year yield represents investors' expectations of the one-year yield, ten years forward. It's a similar case for the 30-year yield: it represents expectations of the one-year yield, 30 years forward; the five-year yield represents expectations of the one-year yield five years forward; etc.
This explains why a "normal" yield curve is generally upward-sloping. Investors generally expect that short-term rates will be higher in the future. Why is this?
In answering that question, we're going to start veering away from the theories behind the term structure (though the expectations theory will remain a part of the discussion), and get into Fed policy, economic cycles, and how the yield curve changes in response.
Investors generally assume that over the long run, the economy is going to grow. Sure, there will be downturns, but the long-term trend is expected to generally be upward.
Also, short-term rates are generally controlled by the Federal Open Market Committee (FOMC) of the Federal Reserve. (Instead of that cumbersome reference, I'm just going to use the term, "the Fed.") I'm going to explain in some detail how they do that, but I'm not going to give it a comprehensive treatment; the Fed has a number of policy arrows in its quiver that it can use to achieve its objectives.
The Fed is responsible for two key policy mandates: controlling inflation, and maintaining full employment. To some extent, these mandates are at cross-purposes. Inflation generally occurs when the economy is growing too fast. Prices are rising due to increasing demand that results from people being flush with cash to spend; wages are increasing because companies are expanding and hiring more people; etc. And all that demand for goods, services, and labor is driving up costs and prices.
On the flip side, stable employment is threatened when the economy is contracting. Companies cut jobs as they anticipate weaker economic conditions. As they forecast lower sales (i.e., less demand for goods and services), they start to trim payrolls, beginning by cutting hours and temporary help, and then by cutting jobs outright.
So the Fed has to walk a tightrope between stimulating the economy such that employment doesn't fall significantly, but not stimulating it so much that growth becomes so strong that inflation results. How does it do that?
Prior to the 1980s, the Fed manipulated the money supply to achieve its policy objectives. It pumped more money into the economy when it wanted to stimulate it, and it withdrew money from the economy when it wanted to slow it down. Pretty simple.
Then, in 1980, three things happened. President Carter had just appointed a hard-nosed economist named Paul Volcker as Chairman of the Fed in 1979. At the same time, inflation had been rampant throughout the 1970s, averaging more than 7% per year, and reaching as high as 13% by the end of 1979 (after averaging around 2% throughout the previous decade). And third, Congress passed the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) in 1980. Prior to the passage of DIDMCA, loan and deposit rates were fixed by the Fed; the Act allowed those rates to float with market rates.
In the aftermath of those three events or trends, Chairman Volcker began using a different set of policy tools to meet the Fed's objectives: he manipulated short-term interest rates, instead of using the money supply. To curb rampant inflation, Volcker immediately began to aggressively increase two key benchmark rates the Fed charged banks: the discount rate, and, more importantly, the Fed funds target rate. (The Fed funds target also determines the rate that banks charge each other to borrow and lend from and to each other to facilitate their liquidity needs.) Those rates determine other key rates, including the prime lending rate, which banks charge their most creditworthy customers. Most credit card rates are still tied to the prime rate. And the Fed funds rate also influences Treasury yields.
Since the Fed funds rate is basically an overnight borrowing rate, it's analogous to a regular savings account rate, but between banks, rather than for individual depositors. It's closely watched by market participants. Treasury yields are based in large part on expectations of what the Fed funds rate will be in the future.
We need to address how the Fed uses the Fed funds target to effect monetary policy. Recall that prior to DIDMCA, the Fed increased the money supply to stimulate the economy and promote full employment, and it decreased the money supply to rein in an overheating economy and thereby slow the rate of inflation.
In the time since the passage of DIDMCA (what we call "the monetarist era," which is still in place today, since the Fed still uses interest rates to effect monetary policy), the Fed increases the Fed funds target to slow down an overheating economy. This has the same effect as reducing the money supply, in that it makes borrowing more expensive. Businesses would be less likely to borrow and expand, so hiring would slow and wage growth would decelerate. Consumers would also be less likely to borrow and spend, so demand for goods and services would decline, thereby reducing the risk of inflation. (I'm only talking about the Fed funds target here, and not addressing the discount rate. The discount rate is important, but the markets focus on the Fed funds target.)
Conversely, when it sees signs of economic weakness, the Fed begins cutting the Fed funds target. The intent is to get businesses and consumers borrowing to stimulate the economy, thereby promoting full employment. (The Fed's definition of "full employment" is a moving target, but recent Fed Chairmen have defined it as a 5% unemployment rate. Obviously that's not "full" employment, but some people are always going to be unemployed at any given point in time, and historically, 5% is a pretty low unemployment rate.)
The Fed engages in these cycles of cutting rates ("easing") and raising rates ("tightening" or "hiking") proactively - or at least it attempts to. More often than not, the Fed gets it wrong, and especially over the last 25 years or so, they have a tendency to overdo it. They cut rates by too much and leave them too low for too long, and thus create asset bubbles that result in recessions. This happened in 2000 with the dot-com bubble and in 2008-09 with the housing bubble. (They created another housing bubble in 2021-22 that is currently in the process of correcting.) And they tend to get behind the market when it comes to raising rates, as they did in 2022 when inflation began to accelerate; as a result, they had to tighten more aggressively than they have since inflation was last this high, in the 1980s. However, a critique of Fed policy and its contribution to asset bubbles is another topic for another day.
Where is all this leading us in our discussion of the yield curve? The short end of the curve (under two years) tends to react to Fed moves, while the long end of the curve (especially the ten-year) anticipates longer-term future Fed moves. We'll talk more about that momentarily. First, let's talk about why the expectations theory means that a "normal" yield curve is upward-sloping. Then, let's address why certain maturities receive greater focus than others, something I alluded to in the previous post.
In general, as noted above, the market expects that the economy will grow over the long run. That means that the Fed will have to raise rates over the long run in order to keep inflation at bay, and that in turn means that long-term expectations of future interest rates will be higher than short-term rates are today. Thus long-term yields will be higher, based on those expectations, than short-term rates, and the yield curve will slope upward from shorter to longer maturities. Again, that's generally true, and only when the economy is growing.
Now let's turn to why certain maturities are more "important" than others. When we talked about the market segmentation theory, we noted that banks and credit unions tend to focus on the two- to five-year maturity range, thus those maturities are considered key benchmarks. Two years is about the average duration of a car loan, and many institutions maintain a similar duration for their investments, including Treasuries. And, looking at a typical graph of a "normal," upward-sloping yield curve, the five-year point on the curve tends to be an approximate inflection point, at which the long end of the curve begins to flatten out.
And finally, the ten-year yield is the benchmark yield for mortgage loans, because that's the approximate average duration of a 30-year fixed-rate mortgage loan. (Mortgages are priced at a spread to the ten-year yield for that reason.) Also, not that many investors, relatively speaking, invest in 20- to 30-year maturities. So 2s, 5s and 10s are considered the key maturities by bond market participants.
When the Fed raises rates, the two-year yield is almost always going to go up. The ten-year yield may go up, as long as traders and investors at the long end believe that future Fed moves will be to raise rates. However, if traders and investors believe that the Fed is done raising rates, or almost done, and that they're going to start cutting rates again soon, the ten-year yield may go down immediately after the Fed raises the Fed funds target. This is because, again, short-term rates react to the Fed, while long-term rates anticipate longer-term, future Fed moves. If the long end (meaning traders of long-term Treasuries) believes future moves will be lower, it will bid yields down based on those expectations.
As a result - and this is where we begin to get into a discussion of what the yield curve tells us about the economy - if the long end believes that the economy is weakening, and the Fed is going to have to start cutting rates longer-term, it will bid yields down: long-term yields will begin to fall in anticipation of those future Fed rate cuts. But if, at the same time, the Fed is still raising rates, because that economic weakness has not yet emerged, short-term rates may continue to rise in response to the Fed raising rates.
And that can lead to a yield curve that is the opposite of what we'd normally see, where long-term yields are lower than short-term yields. This runs counter to the liquidity preference and market segmentation theories, but is entirely in line with the expectations theory: the market expects the Fed to reduce rates long-term, but to continue to raise them short-term. The result is what we call an inverted yield curve:
No comments:
Post a Comment