Flattening Yield Curve (10Y vs 30Y)

[buddtholomew]

As I've said before I manage duration to 5.6 years. If interest rates rise by 1%, I expect LTT to fall by approximately 17% and CD's/Cash to gain a minimal amount. Looking at the FI portion of the portfolio as a whole, I only expect to lose approximately 6%. Fixed income duration will fall and I will be required to purchase additional LTT's to restore the duration to 5.6 years.

Sorry if I missed the explanation, but how did you decide on 5.6%?

No problem, 5.6 corresponds to the VG BND ETF duration.

[stone]

It sure seems that when the four different lines on the chart compress is when we have our stock market crashes. Am I wrong? Thankfully the lines seem relatively spaced right now.

Isn't that the classic "inverted yield curve recession"? The central bank "tightens" by raising short term interest rates so as to put the breaks on and reign in inflation and part of that is a crash.

I'm wondering whether that was just a pre-QE phenomenon though. Perhaps now we have had QE, we won't be getting any meaningful short term interest rate rises for a long time to come? Crashes now will just happen for non-interest-rate-related reasons.

edit: I just googled and found this link which says much the same: http://www.etfguide.com/why-an-inverted ... recession/

[Reub]

So this time it's different? I doubt that!

[buddtholomew]

Actually, the yield curve has predicted 13 out of the previous 10 recessions 

[stone]

So this time it's different? I doubt that!

It was in Japan once they moved to a regime that seems like what we now have:
http://www.etfguide.com/why-an-inverted ... recession/

This chart through 2014 shows 1998’s, 2001’s, 2004’s, 2008’s, and 2011’s recessions in Japan all occurred without an inverted yield curve, even though Japan’s former history also showed the yield curve to be a great recession predictor.

Instead, since the mid-1990’s a flattening of the curve as opposed to a full inversion was all the warning provided for an impending recession.

A History Lesson for the Fed

So, what happened in the mid-1990’s to make Japan’s yield curve inversion no longer a recession predictor?

The Bank of Japan started lowering discount rates toward zero in an effort to counter deflationary forces; sound familiar?

20 years later Japan maintains its short term discount rate below 1% and the Federal Reserve Bank of the United States also has now adopted a similar very low discount rate policy “indefinitely”?.

The inverted yield curve may have worked well during times of inflation, but during times of deflation and low short term interest rates, its predictive power falls apart.  Instead investors should watch for just a flattening of the curve instead of an outright inversion as occurred in all the Japanese recessions since the mid-1990’s to warn of the U.S.’s next recession.

Given the extremely low interest and inflation rates, deflation remains the key risk to your investment portfolio as we outlined in our March Newsletter where we discussed one way to take advantage of deflation through the U.S. Dollar (NYSEARCA:UUP).  Its price is putting together a bullish long term chart pattern and should benefit as deflation continues.  We also discussed the implications a stronger dollar would have on commodities such as gold (NYSEARCA:GLD), which has already seen a 5% decline since due to U.S. dollar strength.

History teaches us that with such low interest rate policies, the U.S. is likely not to see an inverted yield curve again, but this does not mean recessions should not be expected as Japan has had five of them since adopting their version of ZIRP, dealing with deflation for over twenty years now.

[Lang]

Well, it's still possible that some specific parts of the yield curve could get inverted. For instance, the yield on 1Y UK bonds is currently lower than that of 6M bonds. The rest of the yield curve is upward sloping, as usual.

[MachineGhost]

Per the thread title... I guess I've never looked before, but I will admit to being surprised at how yields have generally not been that different for different maturity periods.  Plot below is for 1, 5, 10, and 30-year treasuries.

It certainly doesn't look like QEternity had much effect, if at all.

And you probably need to lag the yield curve chart vs the S&P to see any effect, if at all.  Lowering the rate is actually what you're looking for to correspond with a bear market, since the Fed is always behind the curve.

[MachineGhost]

It sure seems that when the four different lines on the chart compress is when we have our stock market crashes. Am I wrong? Thankfully the lines seem relatively spaced right now.

No, because typically by that time you've got inflationary capacity constraints and the Fed starts raising the FFR/DR rate to "cool" down the economy via destroying businesses by increasing their cost of capital.

[MachineGhost]

I'm wondering whether that was just a pre-QE phenomenon though. Perhaps now we have had QE, we won't be getting any meaningful short term interest rate rises for a long time to come? Crashes now will just happen for non-interest-rate-related reasons.

"Tight money" is tight money, QEternity or not.  What it really means when short term interest rates are higher than long term interest rates, is that theres no confidence to invest in the future because to do so requires a higher rate of interest to compensate for the risk.  The market can cause a "tight money" condition not just the Fed.  The Fed doesn't actually change the T-Bill rate, they change their own internal Discount Rate (charged to member banks who need liquitiy) and the Federal Funds Rate (what member banks charge each other overnight to patch holes in their balance sheets).  "Tight Money" can certainly pierce a bubble in the right environment, but throwing money out of a helicoptor does nothing to stop FEAR.

[MachineGhost]

Instead, since the mid-1990’s a flattening of the curve as opposed to a full inversion was all the warning provided for an impending recession.

The BOJ like the FED engages in QEternity, which means they buy up the long-term end of the yield curve, pushing those yields down.  In combination with short-term rates being lowered, you wind up with a flat nominal yield curve.  It wouldn't be the natural yield curve if the central bank was not intervening in the marketplace.

The yield curve or the Fed raising its rates is not the best nor the only way to predict a recession.  What you're really trying to get at is risk aversion and thats better looked at using other spreads, such as junk vs triple AAA, etc.

[Reub]

Bloomberg is saying that the 5-30 year Treasury spread is the narrowest in 6 years. Does this portend anything?

[Lang]

In Switzerland the 5-50 year spread is 83 bps.