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A World of (mostly) Flattening Yield Curves

Lately,  we've been discussing the Yield Curve, its flattening and inversion and how its different this time (not). This has been termed a "conundrum" by outgoing Fed Chair Alan Greespan.

Many commentators have cited foreign buying of longer-term treasuries as the reason for this "conundrum." While the U.S. yield curve has flattened considerably since its August 2003 peak,that period hardly marks the beginning of foreign purchases of US Treasuries.

Further, if we take a fresh look at curves elsewhere, we see this issue is not limited to the U.S. As the chart below reveals, Yield curves around the globe are flattening.

While numerous rationales try to explain away the US inversion as an anomaly, the excuse making ignores the small fact that the US is not the only country with a flattening Yield Curve: So too are Japan, UK, Germany, Switzerland, Canada and Australia. 

The yield curve inversion naysayers have yet to explain how foreign purchases of U.S. Treasuries are flattening curves elsewhere also.

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click for larger graph

Source: Mike Panzner, Rabo Securities

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Funny, those who try to convince you the Yield Curve doesn't mean anything aren't mentioning this inconvenient factoid of Global Curve Flattening.

 

To paraphrase Panzner:  "Given that spreads between long and short-term rates in many major bond markets (including Japan) have also fallen recently, perhaps "this time" is not so different after all? Could it be that global bond markets are anticipating an impending slowdown?"

Here's a typical set of explanations:

1) stock-market investors fled the crash of 2001, and their alternative-investment strategies have soaked up the supply of bonds and other fixed-income securities.

2) China and other Asian countries are parking their dollars to drive up the value of the U.S. currency and keep their export-driven growth booming.

3) U.S., European and Japanese populations are aging, and with age comes an investment preference for security and income.

4) prices for everything except fossil fuels are being held down by productivity increases, international competition and excess manufacturing capacity.

-Peter Morici, international economist at the University of Maryland's business school

At first blush, these all appear reasonable. However, a closer look reveal the flaws in each of these explanations:

1) This is belied by the enormous amount of cash and cash equivalents -- trillions of dollars in money market accounts -- hardly equates to "soaking up bond supply;" And, the crash began in 2000;

2) Foreign buying of US bonds cannot explain flattening yield curves elsewhere (See  chart above);

3) True dat; Now what about the very young populations in the rest of Asia and the Middle East? Or do we just pretend they are not market participants, and ignore the fact their equity markets have all soared in 2005?

4) Astonishingly misleading statement: Nothing is going up except oil? How about food, building materials, education costs, industrial metals, healthcare, raw goods, insurance, housing, precious metals -- they all have risen dramatically.

While most goods have gone up in price, while a handful of items have come dwn. When we talk about electronics, note that the mechanism that brings their proces down is an economy of scale. The first few units are prohibitively expensive, essentially paying for the factories. The next wave are some what cheaper, and by the thrid iteration, they become mass produced and much less expensive. Think Plasma screens:  They have all plummeted in price -- excepting, of course, for the one screen that I want.

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For the numbers geeks, here are the actual changes in the 10-year vs. 2-year government bond yield spreads for selected countries since August, 2003 (which was the most recent major peak, based on weekly data, in the U.S. spread):

Country	8/29/03 Spread %	Current Spread %	Difference (Positive Value = Flattening)
US	+2.496	-0.009	+2.505
Germany	+1.604	+0.447	+1.157
Japan	+1.264	+1.188	+0.076
Switzerland	+2.186	+0.506	+1.680
UK	+0.438	-0.091	+0.529
Canada	+1.773	+0.118	+1.655
Australia	+0.557	-0.020	+0.577

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UPDATE 1 JANUARY 6, 2005, 1:31pm

Check out this Sunday's NYT for more on this phenomena . . .

UPDATE 2 JANUARY 8, 2005, 8:31am

This is in today's Sunday NYT

The World Isn't Flat, but Its Yield Curve May Be
Economic View
DANIEL GROSS
NYT, January 8, 2006
http://www.nytimes.com/2006/01/08/business/yourmoney/08view.html>

 

Sources:
Michael Panzner, Rabo Securities

Scatter Shots
THOMAS G. DONLAN (Editorial Commentary)
Barron's, MONDAY, JANUARY 2, 2006
http://online.barrons.com/article/SB113598713395735177.html

citing Peter Morici, international economist at the University of Maryland's business school

Tuesday, January 03, 2006 | 05:19 AM | Permalink | Comments (8) | TrackBack (3)
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Comments

From Bob Carver's daily financial comments to argue against what was said above:

We've been discussing the yield curve around here for many moons, but the media apparently just caught on last week and started their usual round of fear-mongering. While it's true that an inverted yield curve has been the best predictor of recessions -- better than all of the Blue Chip Economists individually or as a group -- it has not given, nor will it give, a recession signal until, at the earliest, sometime in March 2006. This looks like a setup engineered by the insiders: get their buddies in the media conglomerates to hammer the public with "bad news" and convince them to sell out. Of course, they got it wrong, just as they usually do.

First of all, the "real" yield curve is measured by subtracting the 90-day Treasury Bill interest rate from the 10-year Treasury Note rate. The media hammers away at the difference between the 2-year and 10-year rates instead. That's one strike against the media: the 90-day rate remains well below the 10-year rate, a normal relationship (not inverted).

Secondly, the forecasting ability of the yield curve for recessions requires the yield curve to be negative (90-day rate above the 10-year rate) for 90 days before a signal is given. That just has not happened yet. So far, the media has two strikes against it.

Finally, even if the true yield curve is negative for 90 days (we won't know for at least three months, and probably much longer than that), a recession signal from this indicator typically will see the stock market continue to rise for several months thereafter -- and a recession usually occurs at least 9 months after the signal is given! Three strikes and you're out, Media Moguls!

Posted by: D STUART | Jan 3, 2006 8:19:37 AM

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