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Investors: Ignore Yield-Curve Fears Because Bond Market 'Rigged'

Investors: Ignore Yield-Curve Fears Because Bond Market 'Rigged'

Thursday, 21 December 2017 07:38 AM Current | Bio | Archive

One of the longer-term questions that is causing occasional anxiety at the moment is what yield curves may be telling us about the economic outlook.

There is an old idea that an inverted yield curve with 10-year yields below short-term interest rates is a “prophet” of recession.

Yield curves have not inverted yet for the most part, but they have come closer. Federal Reserve Chair Yellen was asked about this very point at the last FOMC press conference.


The idea that yield curves can predict recessions would seem to imply that bond traders possess some extraordinary insight into the operations of the economy denied to lesser mortals. To someone who has worked for much of his career on the fixed income floor I would question whether bond traders’ extraordinary insight is quite as extraordinary as might be imagined.

In the past, there was a correlation between inverted yield curves and economic downturns.

The golden rule of economics should be repeated here: “Correlation is not causation.”

Just because a pretty chart can be created with 2 lines moving in the same direction at the same time, does not mean that one event causes the other, which is a point that has much to answer for.

Why was this correlation apparent sometimes in the past?

Back in the 1970s and the 1980s, the largest part of the bond yield was the inflation rate. Inflation was high or very high and bond traders were very sensitive to it. Inflation was also quite closely tied to the economic cycle and central bank policy was aimed at squeezing inflation out of the system.

The result was that if a central bank raised rates, bond traders would conclude that the central bank was fighting inflation head-on and that it wished to slow the economy down. One traders would expect lower inflation in the future as the central bank succeeded, and so there was less need to be compensated for future inflation and so longer-term interest rates would decline. The yield curve would or could invert in expectation that the central bank would succeed in creating an anti-inflation economic slowdown.

Provided the central bank was in any way competent, the slowdown would in fact come about and the predictive power of the bond market would appear to be proved.

This is not the world today.

There are three changes:

First, central banks are more interested in maintaining a balance in the economy than in slowing it down when they tighten, which weakens the relationship with the yield curve.

Second, inflation is less cyclical in its nature, particularly as regards to consumer price inflation as non-market prices have become more important.

Third, inflation is no longer the dominant part of the bond yield. As inflation rates have fallen, bond yields have become more about the real yield and less about the inflation rate.

This then brings us to one of the problems of the modern bond market.

Bond markets are rigged, which is certainly not an overstatement. The overwhelming majority of U.S. Treasuries are owned by investors who do not want to own them.

As Treasuries are owned by investors who have, or better said are in a certain way obliged to own them like the Federal Reserve, foreign central banks, domestic banks, bond mutual funds, and so forth…

The presence of a captive call of investors distorts the real yield on bonds.

Looking to the UK for example, it’s something that investors in the bond market are familiar with.

The UK yield curve has been inverted for years and years (not always of course) while the UK has not been in recession for most of the time.

Etienne "Hans" Parisis is a bank economist who has advised investors on financial markets and international investments.

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The presence of a captive call of investors distorts the real yield on bonds.
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Thursday, 21 December 2017 07:38 AM
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