How to Interpret the Shape of the Yield Curve
Historically most recessions in the US are preceded by significant declines in the differential or interest rate spread between the 10-year T-bond and the 3-month Treasury security. Typically, this narrowing in the spread occurs many months before the onset of the recession.
Conversely, the widening in the spread occurs many months before the beginning of the economic recovery.
What is the reason for these changes in the interest rate spread?
The Conventional View
The most popular explanation of the factors that determine the shape of the yield curve is provided by expectation theory (ET).
According to ET, the key to the shape of the yield curve is that long-term interest rates are the average of expected future short-term rates.
If today’s one year rate is 4%, and next year’s one year rate is expected to be 5%, then the two year rate today should be 4.5% (4+5):2=4.5. Here the long-term rate (i.e., the two year rate today) is higher than the short term (i.e., one year) rate.
It follows then that expectations for rises in short-term rates will make the yield curve upward sloping, as long-term rates will be higher than short-term rates.
Conversely, expectations for a decline in short-term rates will result in a downward sloping yield curve, as long-term rates will be lower than short-term rates.
If today’s one year rate is 4% and next year’s one year rate is expected to be 3%, then the two year rate today should be 3.5% (4+3):2=3.5. The long-term rate (i.e., the two year rate today) is lower than the short term.
According to ET followers, whenever investors expect economic expansion they also expect rising interest rates.
To avoid capital losses, investors will move their money from long term securities to short-term securities. (A rise in interest rates will have a greater impact on the values of long-term securities versus short term securities). This shift will bid short term securities prices up and their yields down. With respect to long term securities the shift of money away from them will depress their prices and raise their yields.
Hence we see a fall in short term yields and a rise in long term yields — an upward sloping yield curve emerges.
Conversely, an economic slump is associated with falling interest rates. Thus, whenever investors expect an economic slowdown or a recession they will also expect a decline in short term interest rates. Consequently, they will shift their money from short-term securities towards long-term bonds. As a result the selling of short term assets will result in a fall in their prices and a rise in their yields. A shift of money towards long term assets will result in the increase in their prices and a decline in their yields.
Hence this shift in money raises short-term yields and lowers long-term yields i.e., an inverted yield curve emerges.
Note that in this framework the formation of expectations regarding short term interest rates in accordance with the expected economic environment determines long term interest rates and in turn the shape of the yield curve.
Shape of the Yield Curve in an Unhampered Market
In his writings, Murray Rothbard argued that in a free, unhampered market economy an upward sloping yield curve could not be sustained for it would set in place an arbitrage between short and long term securities.
This would lift short-term interest rates and lower long-term interest rates, resulting in the tendency towards a uniform interest rate throughout the term structure. Arbitrage will also prevent the sustainability of an inverted yield curve by shifting funds from long maturities to short maturities and thereby flattening the curve.1
Similarly, Ludwig von Mises concluded that in a free, unhampered market economy the natural tendency of the shape of the yield curve is neither towards an upward slope nor towards a downward slope but rather towards flattening.
On this Mises wrote,
The activities of the entrepreneurs tend toward the establishment of a uniform rate of originary interest in the whole market economy. If there turns up in one sector of the market a margin between the prices of present goods and those of future goods which deviates from the margin prevailing on other sectors, a trend toward equalization is brought about by the striving of businessmen to enter those sectors in which this margin is higher and to avoid those in which it is lower. The final rate of originary interest is the same in all parts of the market of the evenly rotating economy.2
Following Mises and Rothbard we suggest that in a free, unhampered market economy a prolonged upward or downward sloping yield curve cannot be sustained.
What then is the mechanism that generates a sustained upward or downward sloping yield curve?
Mises and Rothbard have concluded that this must be the result of the central bank tampering with financial markets by means of monetary policies.
How Fed’s Tampering Generates Upward or Downward-Sloping Yield Curves
While the Fed can exercise control over short-term interest rates via the federal funds rate, it has lesser control over longer-term rates. In this sense long-term rates can be seen as reflecting, to a greater degree, the underlying time preferences of individuals.
The Fed’s monetary policies disrupt the natural tendency towards uniformity of interest rates along the term structure. This disruption leads to the deviation of short-term rates from the natural rate (i.e., from individuals’ time preferences as partially mirrored by the less-manipulated long-term rate).
When the Fed lowers the policy interest rate target this almost instantly lowers short-term interest rates, whilst to a lesser degree affecting longer-term rates. As a result, an upward sloping yield curve develops.
Conversely, when the Fed reverses its stance and lifts the policy interest rate target this lifts short-term interest rates. As a result, a downward sloping yield curve emerges.
As a rule Fed policy makers decide about their interest rate stance in accordance with the observed and the expected state of the economy and price inflation.
Whenever the economy is starting to show signs of weakening whilst the rate of increase of various price indexes start to ease, investors in the market begin to form expectations that in the months ahead the Fed is going to lower its policy interest rate.
As a result, short term interest rates begin to move lower. The spread between long-term rates and short-term rates widens — the process of the development of an upward sloping yield curve is set in motion. This process cannot be sustained without the Fed’s policy of lowering the policy interest rate. Once the Fed has lowered the policy interest rate the widening in the yield spread gets consolidated.
Conversely, whenever economic activity shows signs of strengthening, coupled with a rise in price inflation, investors’ in the market start to form expectations that in the months ahead the Fed is going to lift its policy interest rate.
As a result short term interest rates begin to move higher. The spread between long term rates and short term rates narrows – the process of the development of a downward sloping yield curve is set in motion. Also here this process cannot be sustained without the Fed’s policy of raising the policy interest rate. Once the Fed raises the policy interest rate, the narrowing in the yield spread consolidates.
Note that using Mises-Rothbard ideas, we have concluded that an upward sloping yield curve is the result of investors’ expectations of an easy-money interest rate policy. These expectations are then followed by the central bank actually easing the policy interest rate. This is contrary to the ET framework where the upward sloping curve emerges on account of investors expecting an increase in short term interest rate.
With respect to a downward sloping yield curve we have explained that it emerges as a result of investors’ expectations of a tighter interest rate stance by the central bank. These expectations are then followed by the central bank actually raising the policy interest rate. Again, this is contrary to the ET framework where the downward sloping yield curve emerges on account of investors’ expecting a decline in short term interest rates.
Why Changes in the Shape of the Yield Curve Precede the Pace of Economic Activity
Whenever the central bank reverses its monetary stance and alters the shape of the yield curve it sets in motion either an economic boom or an economic bust.
However these booms and slumps arise with lags — they are not immediate. The reason for this is the fact that the effect of a change in monetary policy shifts gradually from one market to another market, from one individual to another individual.
It is this gradual migration and increase in the effect of a change in monetary policy that makes the change in the shape of the yield curve a good predictive tool.
For instance, during an economic expansion, if the central bank raises its interest rates and flattens the yield curve, the effect is minimal as economic activity is still dominated by the previous easy monetary stance. It is only later, once the tighter stance begins to dominate the scene, that economic activity begins to weaken.