Yield Curve by munificent Blog entry

Blog: Spirit of Money, Financial Fluidity
by munificent

Yield Curve

Nothings for sure, but I glean it will be a long time until they lower rates. The "feeling" is that they stayed low too long as it was ...
"FED RATES FOR 2006 - Some say that they will continue to rise, some say they will stay the same and others believe they may even go down. So, there you have it! Actually, the Federal Reserve is expected to raise rates for a 14th straight time in January to 4.5%".

Date: 1/4/2006 5:15:18 PM ( 18 y ) ... viewed 1681 times

ANALYSIS-Economists, traders eye different yield curves
Tuesday 3 January 2006, 1:36pm EST

By Victoria Thieberger

NEW YORK, Jan 3 (Reuters) - Bond traders have been fixated in recent days on the rare dip in long-term Treasury yields below those of short-term Treasuries, an event that has often presaged economic recession.

But while traders in the bond market have focused on the difference between two-year and 10-year Treasury note yields, some economists say a more reliable economic signal is found in a different measure of short-term interest rates.

They prefer using either the three-month Treasury rate or the Federal Reserve-set fed funds rate as a better predictive tool than two-year notes, which imply a fair amount of longer-term guesswork.

But, as is often the case, the differing perspectives between economists on Wall Street and their trading desks relates to the difference between theory and practice.

Economists don't even agree on what will happen at the Fed's policy meetings in March or May, let alone in two years' time.

"It makes more sense to look at the fed funds rate against the 10-year. The two-year is incorporating the market's best guess of what policy will do over the coming two years, which is speculative," said Michael Englund, chief economist at Action Economics.

"You get a purer measure of how the market is pricing in the trajectory of Fed policy linking the 10-year note to the actual funds rate," he said.

An inverted yield curve can signal recession because it shows that long-term investors are willing to settle for lower yields now because they think the economy will slow and rates will go even lower.

For now, with the fed funds rate at 4.25 percent and 10-year yields near 4.35 percent, the measure is still in positive territory by about 10 basis points. "This gap is not as alarming as market fears suggest," Englund noted.

The yield curve -- the difference in yield between short- and long-term government securities as plotted on a graph -- has predicted every U.S. recession since 1950, according to a recent paper released by the New York Fed.

Last week, the two-year/10-year curve inverted for the first time in five years, and on Tuesday it was essentially flat, prompting a flurry of speculation about whether the bond market was predicting a significant economic slowdown.

RIGHT EVERY TIME?

Because the spread between fed funds or the three-month Treasury bill and the 10-year note is typically wider than that between two-year and 10-year notes, it tends to invert later and to send fewer "false signals" about impending recession, analysts say.

In a widely noticed report from the New York Fed published in October, economist Arturo Estrella preferred this measure for tracing historical comparisons.

"Since 1960, a yield curve inversion (as measured by the difference between 10-year and three-month Treasury rates) has preceded every recession on record. There were no 'false positives' during the period," he wrote.

When this spread remains narrowly positive, as is the case currently, the economy has continued to expand, without falling into recession.

By contrast, there is a greater potential for false signals to be sent by an inverted two-year/10-year spread, since this more commonly dances close to zero in the latter stages of the Fed's tightening campaigns.

Economists also have a clearer historical picture by using one of the shorter-dated rates, since the Treasury did not start issuing two-year notes until 1976.

That means historical comparisons of yield curve inversions before the mid-1970s can only be made using a short rate other than the two-year yield.

But the problem for bond traders is that while economists can use whatever measure they like for analytical purposes, it is only the two-year/10-year note spread that is actively traded in the market.

"The 2s/10s is most widely used because that's what actual traders trade; it's what funds and investment managers implicitly trade," said Bank of Tokyo-Mitsubishi senior financial economist Chris Rupkey.

The 3-month bill rate can also be heavily driven by supply or technical factors that make it an unreliable indicator of money market conditions.

"Picking the 2s/10s as the standard for declaring an inversion is arbitrary, but it's driven by the liquidity of that pair and the tradability of that pair," said Lou Crandall, chief economist at Wrightson ICAP. (Yep)