The Yield Curve

Economists like to talk about the yield curve. Under "normal" circumstances, longer term Treasury Notes and Bonds have a higher yield. Superficially, this makes sense. A longer term bond is "riskier", and should therefore pay a higher yield.

An "inverted yield curve" is considered to be an indication of a coming recession. If you understand the Compound Interest Paradox, you'll understand why this happens periodically. During an economic bust, the money supply is contracting. The Federal Reserve must cut interest rates to prevent a deflationary crash of the money supply. During an economic boom, the money supply is expanding. The Federal Reserve must raise interest rates to prevent a hyperinflationary crash of the dollar.

I originally wrote this article in February 2008. In February 2008, the "yield curve" was, according to Yahoo Finance.

Fed Funds Rate	3.0%
3 month	2.2%
6 month	2.02%
2 year	1.9%
3 year	1.9%
5 year	2.68%
10 year	3.65%
30 year	4.45%

If you look at this chart, you can see the yield curve is decreasing until 2 year bonds, and increasing after that.

Currently, in May 2008, the "yield curve" is:

Fed Funds Rate	2.0%
3 month	1.6%
6 month	1.68%
2 year	2.24%
3 year	2.18%
5 year	2.96%
10 year	3.77%
30 year	4.42%

This is closer to a "normal" upward-sloping yield curve. The Fed Funds Rate is still more than the 3 month and 6 month Treasury rate, which indicates that further Fed Funds Rate cuts are expected.

When analyzing the yield curve, you must understand that Treasury Note/Bond yield will always approximately equal the expected average future Fed Funds Rate. In the above example for February 2008, the 3 month Treasury yield was 2.2%. This means that the expected average future Fed Funds Rate from February to May was approximately 2.2%. Looking back, this was approximately true.

Suppose the expected average future Fed Funds Rate was only 2%. In that case, a bank or hedge fund could profitably borrow at the Fed Funds Rate and buy 3 month Treasury Notes. Suppose the expected average future Fed Funds Rate was 2.5%. In that case, a bank or hedge fund would short sell 3 month Treasury Notes and loan the proceeds at the Fed Funds Rate. There are some transaction costs associated with borrowing and short selling, so the equality is approximate instead of exactly equal.

In other words, the shape of the yield curve is almost ENTIRELY determined by what the Federal Reserve is going to do in the future. An "inverted yield curve" merely indicates that the money supply is contracting and the Federal Reserve is going to be lowering interest rates. An "upward sloping yield curve" means the money supply is expanding and the Federal Reserve is going to be raising interest rates to "fight inflation". (Remember, when the Federal Reserve is "fighting inflation" it really is "decreasing the rate of inflation to stave off hyperinflation". Inflation is usually around 7%-15% or even 30%; the CPI dramatically understates the true inflation rate.)

Why is the normal shape of the yield curve upward sloping? Banks and hedge funds borrow at the Fed Funds Rate to buy Treasury Notes and Bonds. Longer-term bonds are more risky, because you don't know what the Federal Reserve is going to due in the future. This means that banks and hedge funds use less leverage when buying longer-term Treasury Bonds. Hence, the unleveraged yield on those bonds is higher.

Let's consider an example. Suppose the Fed Funds Rate were 5% and never expected to change. Banks and hedge funds want to earn a profit rate of 20% when they invest in Treasury Bonds. Suppose that a leverage ratio of 100x is allowed on 1 year Treasury Notes. In that case, the yield will be 5.20%. Banks borrow at 5% and buy a bond yielding 5.20%, for a profit of 0.20% * 100. Suppose that a leverage ratio of only 10x is allowed on 30 year Treasury Bonds. In that case, the yield will be 7%. Banks borrow at 5% and buy a bond yielding 7%, for a profit of 2% * 10. When you look at this example, it is obvious why the normal shape of the yield curve is upward sloping.

An inverted yield curve signals that the money supply may be contracting (or growing more slowly than usual). The CPI understates the true inflation rate. If you calculate GDP growth using money supply expansion, the US economy is barely growing or shrinking. In a recession, it isn't the economy that's shrinking; it's the money supply that's shrinking. Similarly, in a boom, it isn't the economy that's growing; it's the money supply that's growing.

Summarizing, Treasury Note/Bond prices are entirely determined by what the average Fed Funds Rate is expected to be in the future. If it were different, there would be an arbitrage opportunity for banks and hedge funds. An inverted yield curve means the Federal Reserve is going to have to cut interest rates, to avoid a hyperdeflationary crash of the dollar. A sharply increasing yield curve means the Federal Reserve is going to have to raise interest rates, to avoid hyperinflation. Under "normal" circumstances, the yield curve is upward-sloping, because banks and hedge funds are allowed to use larger leverage ratios when purchasing short-term debt compared to long-term debt

The shape of the yield curve can be *ENTIRELY* explained by expected future Fed Funds Rate changes.