Monday, December 3, 2018

Yield Curve Update

I have written previously about the yield curve.  It appears to me that as interest rates get lower, there is an option value embedded in long term rates because of the zero lower bound.  That means that it is harder for the curve to invert at lower rates.

I suspect this comes from my "Upside down CAPM" way of thinking.  There is a relatively stable expected return on at-risk assets like corporate equity, and fixed income is a way to trade off some of those expected returns in exchange for cash flow certainty.  So, a real 10 year yield of 1% is really a payment of about 6% subtracted from the expected real yield on corporate equities of 7%.  Low real rates are a sign of risk aversion.  They are not stimulative.  It seems that others view them as stimulative.  They are wrong.  And, this gives them a false signal about the yield curve.  It makes it look like an inverted yield curve is less dangerous at lower interest rates, because the low rates are seen as stimulative.  But, an inverted curve at low rates is actually more dangerous, not less dangerous.

Here is a graph of the yield curve slope, my adjusted slope, and forward changes in the unemployment rate.

We have been treading right along the edge of "adjusted" inversion since 2016.  It seems to me that at this point in the recovery, the long term interest rate is a simple and important signal.  If the Fed can keep the yield curve spread between 0% and 1% (or, if my claim that an adjustment is necessary is accurate, then the spread now should be between about 0.75% and 1.75%), then that seems like a great first step in thinking about monetary policy through an interest rate lens.

My main concern is that if my adjustment is accurate, a positive yield curve of 0.5% or so is actually equivalent to an inversion, and even people on the lookout for an inversion won't notice it until it is too late.  The expected December rate hike puts us into inversion territory, in that case.  I have been early to this worry, and was surprised by rising long term interest rates, so you may want to take this with a grain of salt.  But, it seems like something worth watching.  If the unadjusted yield curve inverts, it seems unlikely that the Fed will accommodate nearly quickly or strongly enough.

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