Tuesday, December 22, 2009

What's The Yield Curve Telling Us?

Not as much as you might read, I believe.

In academia, there are three theories to explain the shape of the yield curve. One is "future expectations"; for example, bond investors who expect higher inflation in the future demand higher yields for longer maturity. This is the one that the media is focused on.

A second theory is "liquidity preference". That is, investors would prefer shorter maturities to longer maturities since they might need the funds for other purposes. Yields have to be higher on longer maturity bonds, therefore, in order to induce investors to tie up their funds longer.

The third theory is "market segmentation". There are natural buyers for certain maturity segments - e.g. banks like shorter maturities, pension funds like longer maturities - and the demand from each area determines yields.

I would add a couple of more explanations. When the Treasury is issuing large amounts of debt, yields tend to back up to attract buyers. However, once the auctions are complete, other factors (see above) will drive the bond market.

The final explanation is one that, thankfully, we have not had to focus on much in this country; namely, investor concerns over defaults. Greek bond yields, for example, have soared in recent weeks as investors are concerned about the possible default or renegotiation of Greek debt. Other countries - Spain, Ireland, Italy - have also seen rising yields in the face of weak inflation pressures due to rising default risk.

The US yield curve shape - the spread in yields from 2 year Treasury notes to 10 year Treasurys - is as wide as it has been in at least 24 years. Investors are huddled in the short maturities as there is a "100% certainty" (according to a recent Merrill Lynch portfolio manager poll) that interest rates will be higher a year from now. I am not so certain about this - inflation is muted, the economic recovery is muted, and the Fed seems "on hold" until at least the middle of next year - but of course I might be missing something.

I think longer maturity rates have been rising for a couple of reasons. One is the growing unease that investors are having with huge government deficits worldwide, especially in the US (recall that Congress just raised the US debt ceiling to nearly $13 trillion). And, second, at year end there is little appetite for portfolio managers to add to interest rate risk.

I'll be keep a close eye on the bond market in the coming weeks. A couple of years ago the debt market was the first to realize the financial crisis that was brewing. Then, earlier this year, the corporate bond market rebounded before stocks started their huge rally this past March.

One final thought: If the bond market is focused on inflationary pressures, how come gold prices keep falling?