The yield curve is fact, not fantasy. It is not a theoretical concept but simply a graphic picture of actual investor buys and sells made and paid for with real money. Just because it is fact, though, doesn’t mean that we should necessarily believe it when it tries to predict the future.
A few years ago, the yield curve started changing how it responded to the ups and downs of the economy and of monetary policy.
More specifically, it seemed that the movements of short-term and long-term rates were drifting apart and were less predictable. This presented us with some problems — both theoretical and practical. Economic researchers realized that we needed to know a lot more about how the yield curve actually worked.
The yield curve shows the interest rates that you can expect — the market rates, in other words, if you invest your money in a U.S. Treasury bill, note, or bond that will mature in, say, six months, a year, or five, 10 or 20 years from now.
It shows the relationship, then, between interest rates and maturity. As a practical matter, there are many possible yield curves since there are many different types of debt instruments in the private sector.
The yield curve that most people look to and mean when they say “yield curve” shows only the relationship between market interest rates and federal debt instruments such as Treasury bills, notes and bonds.
The financial market shown in the yield curve is predominantly for “second hand” securities rather than new issues. Investors are constantly adjusting their portfolios to their needs. They may need liquidity to meet commitments or they may have excess liquidity and with to invest it — or move it from short-term securities to longer term securities.
Generally, the longer the maturity the higher the rate. Traditional yield curves show that as a line that rises as maturity lengthens. The theory is that the longer the time the more likely it is that bad things could happen. That explanation works as a general proposition but fails us when it comes to the shape of the yield curve, especially as it moves from the short run to the long run.
The latest research report from the New York Federal Reserve addresses this issue. Written by David Lucca, Samuel Hanson and Jonathan Wright, it is titled, “The Sensitivity of Long-Term Interest Rates: A Tale of Two Frequencies.”
One of the things that the research team found was that, about the year 2000, something happened in U.S. and other major financial markets that changed the relationship between short term and long-term rates. They discovered that “… changes in U.S. short-and long-term rates have become even more tightly linked at high frequencies since 2000 but have largely decoupled at low frequencies. We find broadly similar patterns for Canada, Germany and the U.K.” (“Frequency” in this study is used to indicate debt maturity.)
This is an important finding not just for economists and economic policy makers but for private investors and those who work in industries dependent on long-term interest rates. The list of those includes housing, construction, lodging and utilities, as well as state and local governments. Clearly these are foundation stones of our economy and necessary for economic growth.
This is a problem for both investors and economic policy makers, though. While most of the short-term interest rate movements are the result of expectations about Federal Reserve actions, we know very little about the forces driving long term interest rates.
The Federal Reserve does not attempt to control long-term interest rates directly. The rates reflect to some degree Fed policies in the short-term market, of course, but there are also many other factors that we know of at work — and probably some factors we don’t know about, too.
The recent report by the New York Federal Reserve researchers sheds light on the disconnect between short-term and long-term interest rates.
And its methodology will be very useful as we go through the doors their work has opened to answer the remaining questions.
The researchers have not done all our work for us, though. The juiciest, Hallmark-quality mystery at the heart of this story remains unsolved: What happened in the year 2000 that changed things in U.S. and global financial markets? And there is, additionally, the question of why long-term interest rates remain so low throughout the developed world.
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