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The Banker, The Seer, And The Indicator -...
David Reavill
 January 18 2025 at 02:29 pm
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If you follow the financial markets, you've no doubt heard about the "Yield Curve"—that mysterious market indicator credited with foretelling future economic conditions. Just what is this "Yield Curve?" And why is it deemed to be clairvoyant? I'm afraid if you ask the average financial pundit or even the latest Financial Textbook, you're likely to come away just as confused as before. The standard definition of the Yield Curve measures two different maturities: short maturities and long maturities. Right away, you know we're talking about the bond market, specifically US Treasuries. The Treasury issues many different bonds, Notes, and Bills. Some mature next month; they have a 30-day maturity. And some mature in 30 years (2055). Maturity is when the bond pays back its face value, generally $1,000.OK. Those are the basics. Generally, we expect that a bond that matures later, like the 30-year maturity, will have a higher interest rate (i.e. yield) than a short-term bond. This is because investors need to be compensated for the increase in risk that builds over time. Who knows what the world will be like in 2055? So, to make up for taking on that increase in risk, the yield on a 30-year bond ought to be higher than a 1-year bond. This creates a normal yield curve. And it's working right now. Currently, the yield on a 1-year bond is 4.17%, while the yield on a 30-year bond is 4.79% - 62 basis points higher to compensate for the added maturity risk. You can find that yield curve at: https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2025 At this point, the standard explanation of the Yield Curve goes astray. We all agree that the Yield Curve describes the difference in Yields over a time spectrum. But not always. Believe it or not, there are times when longer maturities sell for a lower yield than short maturities. We're coming off just such a period. From July 2022 until September 2024, longer-term maturities sold for less than short maturities.Completely whacked. While duration (time) is part of the answer, as investors turn negative on future economic conditions, they shorten their maturities, staying liquid and avoiding any bumps in the economy. As inflation began to lift its ugly head in 2022, savvy investors moved to short-term Bonds, selling long-term bonds and inverting the Yield Curve. That's the standard Wall Street and Academic explanation of what we've just been through. But it's only half the story. There is an additional dynamic at work here. We've all made the mistake of viewing the bond market as a monolith. After all, a US Treasury isn't just a US Treasury—they're all the same (except, of course, for their maturities). Actually, they're not all the same. I believe that two different markets underlying the Yield Curve exist, and each market behaves based on a distinct set of influences. The usual measure of the Yield Curve is the two-year maturities versus the ten-year maturities (2s vs. 10s). Going back to the US Treasuries website, we see the 2s trading at a 4.25% yield and the 10s at 4.57%. This is standard, as we'd expect a 32 basis point premium for that additional duration risk. The Banker But now, let's ask the question: Who sets the two-year rate? You're right if you suggest the Federal Reserve Board, the nation's central Banker. Short-term rates are set by the Bank. While two years is admittedly at the long end of their interest rate policy decisions, nonetheless, if we look at the most influential input on two-year bonds, it would be the Fed. The Seer(s) And who sets the 10-year rate? Here, we're much closer to a free market rate. US Treasury investors are among the most sophisticated, large institutions, major universities managing their endowments, insurance companies hedging their actuarial liabilities, and sovereign funds seeking a safe haven. The list goes on and on. But you get the idea that these are the "big boys," and they're taking a calculated financial position based on substantial research. There is a world of difference between these two segments of the Yield Curve. For the short-term curve, the Federal Reserve (the Banker) is highly influential. But for the long-term curve, the Fed's influence wanes, and it's predominantly the investor (the Seer) who rules, just like a free market should be. It puts an entirely different slant on how we view the Yield Curve. It's no longer this passive time difference between short and long maturities. Now, it's as if there is one active player (the Bank—the Fed) who puts up their latest interest rates. While on the sidelines, the rest of the world (literally) stands in judgment of the Fed's move. If the Fed raises rates too high, as they did from 2022 until 2024, the long end of the Yield Curve, the Seer, stays put, refusing to budge, showing to the world that the Fed has overreacted. This two-dimensional Yield Curve best describes what we've just gone through. I believe, as do the Seers, that the Fed raised rates too high for too long, misreading three exogenous factors: the Stimulus, the Federal Government's deficits, and the price of energy. I think the Fed believed (incorrectly) that the economy was "overheating." So, in an effort to "cool" the economy and bring down inflation, the Fed kept tightening rates for 2 ½ years. However, the "Seers" kept their end of the maturity spectrum down, only minimally raising long-term interest rates. This inverted the Yield Curve If the Fed is right, we can now ignore that 24-month tightening frenzy and look forward to the coming "soft landing." However, if the "Seers" are right, the Fed's interest-rate moves were excessive, and we will eventually have to pay the price. Follow me here on ThinkSpot for more stories from the ValueSide.
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