Many economists believe that the shape of the yield curve is a good predictor of economic activity. The recent “inversion” of the yield curve (which displays the relationship between interest rates and the term to maturity of identical fixed income securities) is said to sound the alarm that US economy might be heading for difficult times. The question of why this is so is where the mystery and controversy begin.
Historically, most post-1950’s recessions in the US were preceded by significant declines in the differential--or the interest rate spread--between 30-year T-bonds and 3-month Treasury securities. Typically this narrowing in the spread occurs many months before the onset of the recession. What is the reason for this predictive power of the yield curve?
The most popular explanation is provided by Expectations Theory (ET). This view says that long-term interest rates are the average of expected future short-term rates. Thus, if today’s one year rate is 4%, and next year one year is expected to be 5%, the two-year rate today should be 4.5%. It follows then that expectations of increases in short-term rates will cause the yield curve to be upward sloping, while long-term rates will be proportionately higher than short-term rates. Conversely, expectations of a decline in short-term rates will result in the downward sloping yield curve, while the long-term rates will be proportionately lower than short term rates.
Typically, it is held that an economic expansion is associated with rising interest rates and positively sloped yield curve. Thus whenever investors expect economic expansion, they also expect rising interest rates. This prompts investors to move money to short term securities thereby bidding prices up and yields down. Since money is shifted from long term to short term securities, this depresses the prices of long term securities and raise their yields.
In the same way, an economic slump is associated with falling interest rates. Whenever investors expect an economic slowdown or a recession, they will shift their money from short-term securities towards long-term bonds. This shift raises short-term rates and lowers long-term rates i.e., an inverted yield curve.
Another theory is the Liquidity Preference Theory (LPT), and it seems to have a better explanation for the upward sloping yield curve. According to the LPT, people demand a risk premium for longer maturities over the short-term maturities. Hence, the longer the maturity, the higher the risk of not getting back the initial outlay. Also, there is the risk associated with the rise in interest rates, which will hurt longer-term investments. Where LPT runs into trouble, however, is the explaining the emergence of an inverted yield curve .
The main problem with both the ET and LPT frameworks is that they only deal with interest rates in financial markets. Neither consider that the fundamental or basic interest rate is the natural rate of interest , which mirrors peoples’ demand and supply of savings, that is, individuals’ time preferences. Once you understand the natural rate of time preference, you realize that interest rates in financial markets do not have a life of their own; they are supported by the natural rate.
Murray Rothbard argued that in a free unhampered market economy, an upward sloping yield curve cannot be sustained; it will always set in motion an arbitrage movement from short maturities to long maturities. This will lift short-term interest rates and lower long term-interest rates, resulting in the tendency towards a uniform interest rate throughout the time structure. Arbitrage would also flatten out an inverted yield curve as funds are shifted from long maturities to short maturities.
On the same lines, Ludwig von Mises said that in a free unhampered market economy, the natural tendency of the shape of the yield curve is neither upward nor downward sloping 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” (view the text.)
In a free unhampered market economy, interest rates mirror consumers’ preferences. In this capacity they guide businesses in the most profitable allocation of funding. By responding to interest rates, businesses are, in fact, abiding by consumers’ instructions. What, then, is the primary mechanism that causes the curve to slope so consistently? Both Mises and Rothbard have concluded that the culprit is the central bank’s tampering with financial markets via monetary policy.
Once interest rates in financial markets are lowered artificially, they cease to reflect consumers’ time preferences. This in turn means that businesses, by reacting to interest rates in financial markets and embarking on investments in long term capital projects, are committing errors, which is to say, making investment decisions that are contrary to consumers’ wishes.
While the Fed has an absolute control over short-term interest rates via the federal funds rate, it has less control over the longer-term rates. It is this fact that gives rise to upward or downward sloping yield curves. The Fed’s monetary policies disrupt the natural tendency towards uniformity of interest rates along the time structure. This disruption leads to the deviation of short-term rates from the natural rate i.e. from individuals’ time preferences.
The artificial lowering of short-term interest rates by the Fed generates profit opportunities that prompt investors to borrow money at lower short-term interest rates and invest in higher yielding longer-term investments. To sustain the positive sloped yield curve the Fed must persist with its easy stance. Should the central bank cease with its monetary pumping the shape of the yield curve will tend to flatten and profits from “playing” the yield curve will disappear.
So long as the pace of the monetary pumping is growing and the consequent artificial lowering of short term rates remains in force, there is no way for businessmen to know that they are committing errors. On the contrary, as the loose monetary policy intensifies, it generates apparent profits and a sense of prosperity. The longer the period of loose monetary policy, the more widespread will be the errors. All this leads to a situation where entrepreneurs are committing themselves to unprofitable businesses, which ultimately must be liquidated. It is this liquidation that is called an economic bust or recession.
What usually triggers the bust is the central bank’s reversal of its loose monetary stance. The central bank slows down the monetary pumping and lifts the short-term interest rates. This in turn leads to the flattening or inversion of the yield curve. In order to sustain this inversion the Fed must maintain its tighter stance. Should the Fed abandon the tighter stance, the tendency for rates to equalize will flatten the curve.
In the late stages of an economic expansion investors begin to anticipate a tighter monetary stance and this tends to reinforce the upward slope of the yield curve. Investors begin shifting their money away from long term- securities towards short-term securities. This lifts long-term rates and lowers short- term rates. During an economic slump, brought about by the tighter central bank monetary policy, investors begin anticipating an easier monetary stance and the downward slope of the yield curve is reinforced.
To the extent that investors are forming expectations regarding future course of monetary policy, this only tends to reinforce the shape of the curve as set by the central bank. This means that the shift in the shape of the yield curve is ultimately set by the central banks monetary policies and not by investors’ expectations. At best, expectations can either reinforce or moderate the slope of the yield curve.
Whenever the central bank reverses its monetary stance and thus alters the shape of the yield curve, it sets in motion either economic boom or an economic bust. 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 increase in the effect of a change in the monetary policy that makes the change in the shape of the yield curve a good predictive tool.
For instance, during an economic expansion, the central bank raises its interest rates and flattens the yield curve, the effect is minimal for economic activity is still dominated by the previous easy monetary stance. It is only later on, once the tighter stance begins to dominate, that economic activity begins to weaken.
Finally, studies that purport to extract information about future prospects of the economy from the shape of the yield curve, by means of a statistical torture of the data, are fundamentally wrong. All that one can know about the future direction of economic fluctuations–and our knowledge will always be limited--is to be found in the Fed’s published monetary data.
