The Negative Yield Curve

There has been much chat about negative yield curves as an indicator of recession. A negative yield curve merely indicates that forward interest rates, as implied by the term structure of interest rates, are lower than spot rates. A simple example might help illustrate. Assume the the one period interest rate is 1.5% and the two period interest rate is 1%. The yield curve is negative. The implied one period interest rate, one period forward, is 0.5%. The market thus ‘expects’ interest rates to fall. Whether the implied forward rate is indeed an expectation is the subject of extensive, and inconclusive, academic research. One can conclude however that there must be a significant ‘market view’ imbedded in this forward price if only because of quasi-arbitrage.

If you think interest rates are not going to fall then you would be foolish to invest long-term (or borrow short-term). You invest short-term and wait and , if correct, are able to reinvest at a rate higher than the implied forward. A borrower would borrow long-term and lock in these low implied forward rates. You could exploit your rate view by borrowing long and investing the proceeds short. Hence in the above simple example, you borrow a £100 for two years at 1% pa. After one year you owe £1 but receive £1.5 from having invested the £100 for one year at 1.5%. Provided after one year you can reinvest at more than 0.5% you will have made money. The futures and forward markets allow you to construct these arbitrages at very low cost.

The issue is what is the predictive value of these implied forward rates? Central banks may reduce interest rates if they expect the economy to slow down. Most central banks are more concerned with inflation than the economy per se but the working macro-assumption is that a slower economy reduces inflation. The corollary is that a faster pace of economic growth will boost inflation. This assumption is under some scrutiny at the moment since growth has been quite robust in the last 10 years and inflation has remained stable at a very low level. If the link between inflation and growth is uncertain, why should the markets be collectively predicting interest rates will go lower?

In large part it is because the central banks reaction functions have not yet adjusted to this break down between growth and inflation. They have given clear forward guidance that, despite appearing ineffective, monetary policy is the only tool the CBs have and they will use lower rates and quantitative easing if they believe inflation is drifting away from the target (which for reasons known only to them seems to be universally 2%). This still begs the question; is the market’s expectation of weaker economic growth to come a good forecast? The common assumption is that, whilst it may not be ‘good’, it is the ‘best’ available. The reason is residual faith in the Efficient Markets Hypothesis.

The EMH basically asserts that markets impound all available information. This is not such a daft proposition. The money people have much riding on interest outcomes and can afford to employ the best to reduce the uncertainty surrounding their ‘bets’. There are many experts poring over every little bit of news to assess the potential market significance. On average, market participants probably do have the best view available based on public information. Of course, those with the inside track can do better but that would be naughty.

The yield curve thus probably does give as good a prediction of potential recession as any other public indicator, in part because it logically takes account of every other potential public indicator. The massed ranks of researchers will have included everything and anything relevant and passed it on to the risk takers. The latter will impound the information into market prices and interest rates through their arbitrage activities.

Interest Rates, Bonds and Stocks: the yield curve

Some time next month it is likely stock markets will correct lower. They often do at the start of the summer. This time we may also have the added influence of a sovereign debt default by Greece and the prospect of an interest rate increase by the Federal Reserve, quite possibly quickly followed by the Bank of England. Equity markets seem unmoved. They continue to push up despite being near the top of any technical boundaries one might use. This is quite odd. Equity markets are forward-looking and they seem not to see any of this or believe it unimportant. Indeed, both the Federal Reserve and the Bank of England have openly criticised the ‘markets’ for being overly optimistic about the path of interest rates. These two central banks, which after all have the power to set short-term interest rates, are telling markets that interest rates will rise faster and higher than the ‘markets’ are pricing. This is odd.

The ‘markets’ that price implied forward interest rates are not equity markets as such but the bond markets, but they all join up. At any point there is a market or spot yield curve. This is implied by actual risk free government bond prices and corresponds to a series of yields for each zero coupon bond (often notional) maturity. A zero coupon bond is just a bond that pays a value (usually 100) at maturity and no regular coupon or interest. From this yield curve it is possible to calculate implied forward interest rates, e.g. the 3 month interest rates every 3 months forward (anyone interested in the calculations should see my Personal Finance series of blogs). So, when the Fed says the market is too optimistic, it means that the spot or current yield curve is too flat e.g. the difference between 2 year interest rates and 30 year interest rates should be greater. So what will happen when the Fed starts to raise interest rates?

The market knows that the interest rate increase is inevitable and coming soon (if they do not then perhaps i should come out of retirement!). Unless the interest rate increase is accompanied by some material new information, then logically the market will not respond much. The yield curve will simply flatten further as short-term rates rise but longer maturity rates rise less than in proportion. The assumption that is often heard in the press, that the first interest rate increase will cause sell off in the bond markets, does not follow automatically. The sell off may be quite muted and short-lived. In economic terms this will be the market telling the Fed that he economy remains fragile and even a small rise in rates will choke off growth and any incipient rise in inflation. Of course, time will tell and we shall see but bear in mind that yield curves can change shape quite dramatically.

This may also explain why the equity markets have become complacent. If the yield curve is expected to flatten then the valuation effect of an interest rate increase is muted because the discount rate, typically a long-term interest rate, does not increase very much and is not expected to increase for very long. The key response that all should focus on after the first interest rate increase is how the yield curve, and hence implied forward interest rates, behaves. If it flattens then any equity market sell off will most likely be corrective, shallow and short-lived. If the yield curve steepens then a much deeper correction may be in the cards.