Wednesday, June 14, 2006

The Fed and the Flat Yield Curve

The Fed so far has raised interest rate 16 times and the 30 year bond has gone up 1/2 percent to 5%. Now the 3 month T-bills, and everything up to the 2 year bond, has incremented accordingly. Right now the graph is flat, there should be a 3% difference between the 30 and 2 year bond (More time implies more risk).

The Fed appears to be pushing on a string, the world bond market is too big for them to have any real influence.

The flat yield curve could be a precursor to a recession. It tends to suggest that the banks are flush with too much cash, and/or it could also imply that short term maturities are where the major players are putting their money.

If you can raise the Fed Funds rate 4 percent and the 30 year bond doesn't maintain a 3% spread with the 2 year bond, then you can safely deduce that something is running counter to the market and common sense.

If you disregard the Fed as a Player, then the market seems less out of kilter. There is also another factor that could be a prime mover of the US Bond market. Years back, the government (financing the National Debt) got caught borrowing long on the 30 year Treasury's at a high interest rate. Somebody pointed out at the time that the government could do better (interest wise) if they borrowed in the short term market at lower rates and just turned the bonds over (reissue them). Even with the flat yield curve they are not at a loss. Notice also how the 30 year bond reappeared after being phased out? The government could be changing horses here, going from short term maturities to long.

Another thing to consider, the concept of risk seems to have left the building.


bubble_watcher said...

I'm going to add this chart to the discussion:



A move above 5.50% on the long bond yeild has significance here in that it will imply that the long term downward trend in interest rates for the bond market is over.

Also, during the Great Depression, corporate bond market interest rates went up as investors demanded a return of their money; vice seeking a return on their money.

IMO, falling tax receipts and rising internal obligations will in all likelihood have a similar impact on the 30 year bond as well.

There are subtle differences between this depression and the previous one - mostly for the worse.

Jim in San Marcos said...

I agree, your quote

"IMO, falling tax receipts and rising internal obligations will in all likelihood have a similar impact on the 30 year bond as well."

points out to the legislative failure of thinking in the 30"s. They raised the tax rates and their income decreased. The common man thought that if you raise tax rates you increase revenue, the exact opposite occured in the 1930's.

The thing that scares me is the 30 year bond holder at 5%. If interest rates pop up, to say 10% that note will take a 50% haircut. I am too old to wait 30 years for a full return of my capital.

Thank you for your post Bubble_Watcher