The yield curve represents the interest rate on varying maturities of debt for one particular type of risk. For example, the U.S. Treasury yield curve indicates the cost for the U.S. government to borrow money for short periods (like 1 month) out to longer periods (like 10, 20, or 30 years). A flat yield curve, would be one where the cost to borrow at these various terms is the same, while a “normal” yield curve is one where longer-term borrowing pays a significantly higher rate for longer terms.
The yield curve is also known by an alternative version called the term spread, which might compare the ten-year interest rate with the one-month interest rate for one risk level (e.g., the U.S. government). This is very different than the credit spread, which compares a risky and a safe asset that have the same maturity (e.g., the TED spread which is 3m T-bill minus 3m overnight rate). All of this is typically measured in “bips” or basis points which represent 1/100th of a percent. Thus, 100bps = 1%.
OK, on to the topic… Right now, the yield curve is getting progressively steeper (i.e., the term spread is widening). Currently, the two-and-ten year term spread is at 118 bps (see below). Some people read this as the potential for a booming economy on the horizon. It could also be indicative of future rising inflation (Treasury Yields Stabilize After Big Jump – WSJ – paywalled but WSJ). This is somewhat in contrast to other indicators like the Conference Board’s Leading Economic Indicators (LEI) index, which has been declining for several months (Bubble Markets Display Bizarre Behavior Right Before They Tumble (forbes.com)). So, what appears to be on the horizon here? Good times with potential for inflation? Or is the market just reacting to a “risk-on” environment where investors are pivoting out of safety and into equities? Finally, what does this say about the Fed’s ability to keep rates low for the forseeable future?
So why has the Fed pledged to keep interest rates low for the forseeable future? While things might be looking up in the future, they haven’t been looking all that good of late (Fed stresses its commitment to low rates as economy stumbles (apnews.com)). The Fed cut rates in 2020 in an effort to shore up a weak pandemic-impacted economy. In response, people went out and borrowed money to purchase assets like homes (Household debt rises to $14.6 trillion due to record-breaking rise in mortgage loans (cnbc.com)). Where might the Fed go from here? If long-term rates rise, and mortgage rates rise, what might happen down the road to those people who borrowed lots of money in 2020 and 2021? It might not seem like a big deal to those people who are just shopping to move from one home to another, but builders might be faced with unsellable homes that they hoped to sell on the heels of the hot 2020 market (Lumber prices top $1,000 as single-family housing starts drop 12% (cnbc.com)).
Looking back at 2019, there was another event that occurred which led many people to believe that there would be a recession in 2020. In October 2019, the yield curve inverted, meaning that short-term lending rates exceeded long-term rates. This has often predicted recessions, and it’s worth noting that every recession since at least the 1980s has been preceeded by a yield curve inversion. Now… no one could have predicted the COVID-19 pandemic, but this is some evidence that the disease struck our economy at just about the worst possible time of preparedness. A yield curve inversion plays into our understanding of expectations of future interest rates to a degree, but is likely more indicative of a rush towards liquidity. As banks and other institutions seek to become more liquid, they might push to have a shorter term on lending, driving those borrowing costs higher, while leaving the long-rate pretty much unchanged.
Questions you might answer:
- Does it seem as though the yield curve steepening of 2021 is predicting a booming economy? Or is this more indicative of inflation? Do you have any other evidence that could broadly supporty your beliefs?
- Did the inversion of late 2019 accurately predict the economy was poorly positioned for a shock of any kind — let alone a large shock. In spite of the fact that the unemployment rate was at historic lows in late 2019, there were signs everywhere that the economy was not all that healthy. What other evidence to you have to support your opinions?
- What would rising rates mean for the housing sector and investment? Is there a problem on the horizon for unsold homes or projects? Or is a rise of 100bps something most companies can sustain? What happens if credit spreads suddenly spike? Provide some evidence to support your opinion here.
- You are free to discuss peripheral work to this topic as well, as long as you incorporate discussions of the yield curve, term spread, or even credit spread into your writeup.