10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity
fred.stlouisfed.org
fred.stlouisfed.org
However, this is the first time this kind of yield inversion has occurred right after the Fed announced plans to stop reducing its balance sheet, which grew to unprecedented levels in response to the financial crisis. You can see the enormous impact that the Fed's balance sheet growth had on the monetary base here: https://fred.stlouisfed.org/graph/?g=lIdk
Until recently, the Fed had been reducing its balance sheet by up to $54B/month; it announced plans to stop.[a][b] How and to what degree has this impacted yields?
As additional context, consider that the yield inversion has occurred during a rise in import tariffs, trading restrictions, and public threats between the US and China (and now Mexico too). So far, the economic impact of these trading spats on the US economy has been small.[c] Could the recent yield inversion be caused more by a global flight to safety. in conjunction to the Fed's actions, than the actual risk of a US recession?
Is it even possible to answer these questions with certainty? I'd be leery of any predictions for the US economy based solely on this recent inversion of the yield curve.
[a] https://www.federalreserve.gov/monetarypolicy/bst_recenttren...
[b] https://www.reuters.com/article/us-usa-fed-balancesheet/fed-...
[c] https://www.nytimes.com/2019/05/07/us/politics/trump-tariff-...
To reduce its balance sheet, the Fed has rolled down assets, allowing them to mature. By choosing to not reinvest the principal from these matured assets, they reduce the size of the balance sheet. My understanding is that the reinvestment occurs in longer dated securities, which would put flattening pressure on the curve. Estimates indicate a reduction of these purchases would raise 10y yields 40-60bps [0]. All other things being equal, this would lead to steepening of the yield curve.
> I'd be leery of any predictions of recession in the US based solely on yield inversion.
Not all yield curve inversions have preceded recessions, but almost all recent recessions have been preceded by yield curve inversions. Yield curve inversions lasting 10 days or longer tend to have more predictive power. The inversion in March did not last that long, for example. On average, a recession follows 14 months after an inversion [1].
[0] https://www.ft.com/content/828169e8-8902-3d5a-903d-586bf22cc...
[1] https://www.advisorperspectives.com/articles/2019/04/01/a-hi...
How has that affected expectations and behaviors?
I'm aware. Markets are forward looking. As you can see, yields have dropped precipitously since the announcement, and the curve has flattened. This is consistent with expectations of increased purchases of securities in the tail end of the curve.
That's my point :-)
It's been a reliable signal in the past, but perhaps this time is different.
Interestingly, some economists postulate that such an inversion may be somewhat causative of recession, due to increased short term funding costs relative to long term funding costs.
Yes, we're in agreement :-)
> Interestingly, some economists postulate that such an inversion may be somewhat causative of recession...
That could be true... I don't know.
When the value of the spread between a long dated (e.g. 10Y) and a short dated (e.g. 3m) instrument increases, the yield curve is referred to as 'steepening'. When this spread decreases (even when becoming more negative), the curve is said to 'flatten'.
/ steep
- flat
\ even flatterhttps://fred.stlouisfed.org/graph/?g=o4ro
Of course maybe this time is different...
Then in a recession, the Fed reduces rates to heat it up.
Historically, interest rates drop 5 percentage points in recessions.
But since rates are currently just north of 2 percent, there's no room to maneuver. If a recession hits now, the Fed cannot drop rates 5 percentage points. They'll run out of ammunition at the zero lower bound.
There's no reason rates cannot go negative. Bund yields (Germany) are negative currently [0]. As a matter of policy, there are other approaches that may be taken. A modified Taylor rule with a zero lower bound may deliver optimal policy if the neutral rate falls below zero [1].
[0] https://www.bloomberg.com/markets/rates-bonds/government-bon...
QE showed that the Fed has more options than lowering interest rates.
But long-term structural patterns take far more capital to arbitrage and your position can be deep under water for years at a time.
There just isn't that much patient capital.
This isn't necessarily true. There are demonstrable, persistent calendar effects that can be reliably traded. Such trading can be thought of as a service being provided to market participants for a fee (e.g. balance sheet as a service).
One example of a calendar effect that is likely not easily monetized is the 'Christmas effect' for VIX [0] due to decreases in trading activity.
The treasury market reflects demand for 'risk-free' securities, which functionally serve as bank accounts for corporate entities without access to bank reserves on the Fed's balance sheet. When market participants expect rate cuts in the future, long term assets with a locked in yield become more attractive to hold relative to short tenors, as the short dated treasuries need to be rolled more frequently.
Additionally, it may be that the curve inversion itself causes greater expense in short term funding (e.g. overnight), leading to potential contractions in economic activity.
Expectations of Fed rate hikes and cuts are reflected in the fed funds futures market, where participants estimate future values of the fed funds rate. Currently, the market implies a 94% chance of at least one rate cut by December [0].
[0] https://www.cmegroup.com/trading/interest-rates/countdown-to...
[1] https://www.google.fi/amp/s/amp.ft.com/content/855d23e2-83b7...
There's no arbitrage in the strict sense, that's clear.
But there's none in the statistical sense, either. Yield curve inversion doesn't happen all that often, how are you going to confidently bet that what happened the last few times will happen again this time, given that n is so low and there's always the issue of regime change?
[0] https://www.frbsf.org/economic-research/publications/economi...
The synthetic instrument 3m-10y is referred to as a 'curve'. It can be denoted 3m-10y. Convention is such that the value of a curve is long dated tenor minus short dated tenor.
One names the spread by denoting the two instruments, by convention first the short dated, then the long dated (for example, 2y/10y or 3m/10y or indeed 3m-10y, where the '-' is a hyphen).
One computes the spread by subtracting the short dated yield from the long dated one (ie, 10y - 3m, where the '-' is a minus).
It contains gems such as this:
> Section 4.11. FRN Convention; Eurodollar Convention. “FRN Convention” or “Eurodollar Convention” means, in respect of either Payment Dates or Period End Dates for a Swap Transaction and a party, that the Payment Dates or Period End Dates of that party will be each day during the Term of the Swap Transaction that numerically corresponds to the preceding applicable Payment Date or Period End Date, as the case may be, of that party in the calendar month that is the specified number of months after the month in which the preceding applicable Payment Date or Period End Date occurred (or, in the case of the first applicable Payment Date or the Period End Date, the day that numerically corresponds to the Effective Date in the calendar month that is the specified number of months after the month in which the Effective Date occurred), except that (a) if there is not any such numerically corresponding day in the calendar month in which a Payment Date or Period End Date, as the case may be, of that party should occur, then the Payment Date or Period End Date will be the last day that is a Business Day in that month, (b) if a Payment Date or Period End Date, as the case may be, of the party would otherwise fall on a day that is not a Business Day, then the Payment Date or Period End Date will be the first following day that is a Business Day unless that day falls in the next calendar month, in which case the Payment Date or Period End Date will be the first preceding day that is a Business Day and (c) if the preceding applicable Payment Date or Period End Date, as the case may be, of that party occurred on the last day in a calendar month that was a Business Day, then all subsequent applicable Payment Dates or Period End Dates, as the case may be, of that party prior to the Termination Date will be the last day that is a Business Day in the month that is the specified number of months after the month in which the preceding applicable Payment Date or Period End Date occurred.
That said, with annotation and explanation it would only be incrementally more valuable. TA is like reading tea leaves.