nedsaid wrote:nisiprius wrote:Very cool. You can also see a very different presentation of the yield curve flattening on the
dynamic yield curve web page at stockcharts.com
Since the idea that a flattening or inverted yield curve predicts recessions has been around for a long time. Wikipedia's article says "Campbell R. Harvey's 1986 dissertation showed that an inverted yield curve accurately forecasts U.S. recessions." Since economists presumably have heard about this, yet economists are famously bad at predicting recessions, I suspect it can't be as simple at all that.
And even if an inverted yield curve predicts a recession, does a flat yield curve predict an inverted yield curve... and does a less steep yield curve predict a flat yield curve?
The reason that yield curves get inverted is that the Federal Reserve Bank is pushing up short term interest rates to slow down the economy and thus take inflationary pressures out of it. If long term rates actually start to decline, it is a signal from the bond market that recession may well be coming. If long term rates go up with short term rates, the bond market is signaling that the economy is relatively strong and that inflation pressures are continuing to build.
The thing is, the bond market is made up of pessimists. They are sort of the canary in the mineshaft. I also have wondered if the brightest minds on Wall Street are on the bond side of the market and not the stock side of the market. If you want to check the health of a company check on the bonds it has issued and see how the market is treating them. Bond analysts seem to sense trouble before the stock analysts do. Ditto for the economy as a whole. This is one reason I suspect the best minds are on the bond and not on the stock side. Maybe stock people are goofy, wild-eyed optimists. Bond people are more sober realists, they seem to live by Murphy's Law, if something can go wrong, it likely will. I think some bond analysts believe Murphy was an optimist.
You should meet some High Yield Bond people
. They can be worse than equity people
.
On the Sell Side, equity by its nature has to be bullish. You can't push an IPO or a secondary offering without a good story around it. Ditto M&A transactions etc.
And as a Sell Side analyst you have to have some stocks for clients to buy, ideas for the sales force to pedal. It's also a health hazard to issue "Sells" which is why they very seldom do.
Bond people tend to be pessimistic because their upside (as investors) is limited. If all goes well, you get paid your coupons and your $100 at maturity.
It's not so much the quality of the intellect, as the risk-reward spectrum. They are like cancer doctors in a way. If all goes well you are back to where you were before the diagnosis, if it does not...
The ratings agencies are held to not have the best people (at least on corporate credit) because the best people migrate to sell side credit analyst roles or these days to the buy side. Hence the various gibes at ratings agency people in e.g. The Big Short.
Markets try to anticipate the future and also attempt to incorporate all known information. Since markets are built upon expectation, weird things happen when those expectations are not met. So the bond market might signal continued inflationary pressures ahead with a hike in long term rates but the actual inflation might not show up in reality. Or long term rates might go up a bit but not as much as the stock market had feared and I suppose the stock market could actually rally!
It's really gaming what the Central Banks think, rather than what we think. And investors: seeing the flow of money. So what moves the market is that the Fed (or whoever) tightens more/ less/ the same as expected. If inflation is above expectations, then the CB will tighten faster than expected.
It's a game of estimating what everyone else thinks.
What I am trying to say is that the market signals what it thinks will happen but those signals often turn out to be false alarms. Long rates go up on inflation expectations, a couple days later the actual inflation data shows less inflation than feared, long rates fall again and the stock market potentially rallies. If this were not so, then yield curves and the like would be infallible economic indicators. It is the old joke about economists predicting eight out of the last five recessions.
What drives the long end of the curve is the short end, because that drives the cost of finance of inventory at the long end. At least that's what I think is going on, looking back at the 1990s and 1994 in particular.
Also long bonds are thinly traded. Because the buyers are largely insurance companies that need them to hedge liabilities (pension funds as well) eg annuities. They then hold these bonds until maturity.
In the UK the 30 year bond (and the 50) actually tend to trade at a *lower* yield than the 10-20 year bonds, because of this phenomenon. The pension funds and insurance companies buy them for actuarial reasons, and then do not sell them.
The problem, as you can imagine, is even worse with inflation linked bonds-- Indexed Linked Gilts are c. 25% of total UK government debt outstanding.
A complication is the Fed and the Bank of England, ECB are all now big holders of government debt at the longer maturities. That probably has lowered interest rates, whether it will at some point "snap" back is anyone's guess.
