Posts tagged: Yield Curve

The Yield Curve – What is it Signaling?

“During a tightening cycle it is normal for short-term rates to rise more than long-term rates, resulting in a flattening of the yield curve. what is the yield curve signaling? Could it be that the growing chatter of a possible U.S. recession has some merit? Or are these fears overdone?

The Ground Rules

During uncertain times like these, we look to reliable indicators of past recessions to see what they are telling us. Although many variables such as growth in hourly earnings or high yield spreads over Treasury bonds have been shown to “predict” recessions in advance, the slope of the yield curve remains a powerful indicator of what lies ahead for the U.S. economy.

Perhaps I’m partial to this indicator because of its origin. I’ve had the privilege of having many good professors teach me throughout the years, standing on the shoulders of giants, if you will. One of these was Campbell Harvey, an investments professor of mine at the University of Chicago Booth School of Business. Professor Harvey wrote his dissertation thesis on how the slope of the yield curve predicts future economic growth.

In his dissertation, Professor Harvey measured the yield spread between 3-month and 5-year Treasuries and then compared the resulting yield curve to consumption growth. He discovered that when the yield curve inverts, such that short-term yields are greater than long-term yields, an economic recession can be predicted to occur 12 months later on average. Since Harvey first published this theory, the yield curve has inverted three more times (1989, 2000, and 2006) predicting subsequent U.S. recessions in 1990-1991, 2001, and 2007-2009. In each of these times, the Fed was in the midst of a tightening cycle.

 

At What Rates Could The Yield Flatten?

Using history as a guide, let’s take a look at three different methods for assessing the levels at which the yield curve has gone on to flatten or invert.

Fed Funds Rate

Historically, the Fed has stopped raising rates when the federal funds rate approximately equals U.S. nominal GDP, which is currently about 3.9% (2.4% plus inflation of 1.5%). If we assume that the sustained U.S. expansion continues at a modest pace and we move toward the Fed’s inflation target of 2%, then the Fed may complete its tightening cycle with the short-end of the curve ending up between 3% to 4%. Read more »

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The Effects of a U.S. Rate Hike on the Yield Curve

by Gerald Hwang of Matthews Asia

“The fear of a rate hike is powered by the tacit assumption that rates along the entire yield curve will rise in tandem. Only such a parallel upward shift would raise discount rates on all cash flows from risky assets (e.g. equities and corporate bonds). Consequently, the present value of those assets would decline, if cash flows stay the same. Importantly, the Federal Reserve holds sway over only short-term rates through its setting of the federal funds rate. This policy rate may be affected more by Federal Open Market Committee assessments of economic growth than by inflation.

Moreover, this short rate is a weak lever on longer rates. Rates at longer maturities embed the compounded effect of expected future real rates, expected inflation and a term risk premium that captures the volatility of these factors. Market anticipation of higher future inflation, or the possibility of inflation surprises, will be expressed as higher long-term interest rates. The Fed’s credibility anchors these market expectations, and the loss of that credibility is perhaps the biggest risk to long-term rates.

In rate hike cycles over the past 20 years, Fed credibility may have been enhanced by the very act of raising rates in the first place. One indication is in the flattening of the U.S. yield curve. In each cycle, short rates rose more than long rates. Interestingly, in two of the past four hike cycles, the longer part of the curve (10-year to 30-year) declined in yield. A parallel shift in the yield curve is as rare as receiving the equity market’s long-term average annual return in any single year. Most likely, a future federal funds rate hike will not translate into higher rates all along the curve.

As seen in Figure 1, only the 1994 rate hike cycle saw an upward shift in the entire yield curve, yet yields at longer maturities rose less than those at the front end.

 

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