Interpreting Treasury Yield Trends Sam Park October 2004 Treasury Yield Overview Treasury securities vary according to maturity ranging from short-term (e.g. three-month Treasury bills) to long-term (e.g. 20-year Treasury bonds the 30-year Treasury bond was discontinued as of 2/18/02). The yields on these securities represent a base interest rate or minimum interest rate that investors demand. U.S. Treasuries are backed by the government, and therefore, considered as risk-free. For this reason, market participants closely monitor these rates because they also signal important economic and market trends. This report will analyze the historical yields and the relationship between the yields offered on U.S. Treasury securities and their respective maturities. Treasury Trends Many laymen may think that interest rates always move in tandem. However, the rates on bonds of different maturities move independently of each other. These rates generally move in the same direction; but historically, their movements have occasionally varied with each other and have even moved in opposite directions. Figure 1 plots monthly averages of six U.S. Treasuries (i.e. three-month, two-year, five-year, 10-year, 20-year and 30-year). Figure 1: Treasury Yields 18.00% 16.00% 1 1 1 8.00% 6.00% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 3-mth 2-yr 5-yr 10-yr 20-yr 30-yr discontinued Normally, short-term bonds carry lower yields to reflect that the investment has less risk. This underscores the theory that the longer an investor s cash is tied up, the greater the yield premium demanded to compensate the investor for the exposure to interest rate risk. Simply put, investors expect higher returns for locking in their investments in longer-term securities.
Yield Curve Overview Plotting the rates for various maturities of U.S. Treasury bills and bonds produce what is known as yield curves. (Despite the name, yield curves do not always have to be curved.) Figure 2 illustrates the yield curve for October 6, 2004. 6.00% Figure 2: Yield Curve As of October 6, 2004 5.00% 3.00% 1.00% 1 mth 3 mth 6 mth 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr The current yield curve shows a positive sloping curve, which is considered normal because the longer maturities indicate higher returns than those that are shorter. As Figure 1 suggests, the curve may twist into other shapes, each signaling turning points in the economy. Recognizing the various types of yield curves provide indications of the U.S economic outlook. Normal Yield Curve The yield curve gently slopes upward when bond investors expect the economy to grow smoothly without significant shocks. Under these conditions, investors who risk their cash for longer periods expect higher returns than those who risk their money for shorter periods. Therefore, interest rates move progressively higher as maturities lengthen, producing a positive sloping curve. Steep Yield Curve Historically, the 20-year Treasury bond yield has averaged approximately two percentage points above that of three-month Treasury bills. In situations when this gap increases (e.g. 20-year Treasury yield rises relatively higher than the three-month Treasury yield), the economy is expected to improve quickly in the future. This type of curve can be seen at the beginning of an economic expansion (right after the end of a recession). Here, economic stagnation will have depressed short-term interest rates; however, rates begin to rise once the demand for capital is reestablished by growing economic activity.
Flat or Humped Yield Curve A flat curve is apparent when all maturities have same yields, whereas a humped curve results when short-term and long-term yields are equal and mid-term yields vary from those of the short-term and long-term. A flat curve sends signals of uncertainty in the economy. This mixed signal can revert back to a normal curve or could later result into an inverted curve. Inverted Yield Curve An inverted curve occurs when long-term yields fall below short-term yields. Under this abnormal and contradictory situation, long-term investors will settle for lower yields now if they think the economy will slow or even decline in the future. An inverted curve indicates a worsening economic situation in the future. Referring back to Figure 1, a flat yield curve occurred when the yields cluster together as they did in late 1989 and late 2000. The curve inverts when the short-term yield exceeds the longterm yield. A normal curve emerges when the maturity and their respective yields are moderately and progressively arranged from shortest-term (lowest yield) to longest-term (highest yield). The yield curve grows steeper as these gaps widen. Yield Curve Trend As shown earlier, the current yield curve is normal, but it is worthwhile to analyze the historical trends of the gap between the maturities. Figure 3 charts the yield differential (gap) between the 20-year Treasury and three-month Treasury yields. Under normal conditions, the difference would be positive. The difference will be zero under flat circumstances and negative for inverted situations. The peaks also indicate a steep curve.
Figure 3: Yield Differential (20-year vs. three-month) 5.00% 3.00% 1.00% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004-1.00% By examining the above chart, we can assume that the yield curve had started to flatten as we headed into the new millennium. The curve was even slightly inverted in year 2000 and started to revert back to flat and then to normal conditions by the end of the year. This recent trend seems to have peaked and has leveled. The gap between the two Treasuries seems to be have started to contract as the 20-year Treasury started its consistent decline since May 2004 while the three-month Treasury simultaneously rose. This indicates that the yield curve is on the move towards a flatter curve. Interest Rate Factors When we headed into year 2000, the Federal Open Market Committee had reversed its aggressive monetary policy and commenced lowering the fed funds rate by engaging in the open market operations (See report Summary of the Monetary Policy and Economic Outlook ). Lower fed funds rate allow banks and institutions to tap into the reserves maintained at the Federal Reserve at lower rates. In turn, these institutions can offer loans to banks that need to meet reserve requirements, and these institutions can earn interest from those loans used with the borrowed reserves. As fed funds rates and/or reserve requirements go down, loans (e.g. home loans) are made at lower rates, and/or more cash is available for loans. Such a scenario would explain a rapid rise in the housing market. Home buyers would have access to cheap capital to purchase their dream
homes. Here is a classic case where demand would outpace supply. In the last few years, 30- year fixed rates have fallen below 5%, prompting demand for housing purchases. Since the demand outpaced the supply of homes, housing prices have skyrocketed in certain markets. In markets like San Diego, many houses have more than doubled since the year 2000. However, the housing market has started to cool as rates have recently started their ascent. The demand for long-term mortgages throughout 2001 and 2003 partially explains the widening gap between long-term and short-term Treasury yields. Nevertheless, this gap has started to contract as seen in Figure 3. Recently, rising fed funds rates combined with several shocks in the economy (i.e. record high oil prices, corporate accounting scandals, etc.) may justify the flattening of the yield curve. The current yield curve does not indicate a major crisis is in the near future; however, the exuberant attitude in the mid- to-late 90 s has turned to that of a moderate and even skeptical outlook in the recent period. Fannie Mae The government does not directly guarantee Fannie Mae s debt instruments; however, the institution has special privileges to directly borrow from the U.S. Treasury. Fannie Mae, which offers capital to low-to-middle income homebuyers by purchasing mortgages from banks, has been accused by a Federal oversight agency of overly engaging in aggressive and irregular accounting policies; Among other charges, Fannie Mae is said to have inappropriately created reserves to smooth out earnings. This accusation is likely to result in earnings restatements and substantial fines for Fannie Mae and associated participants. This will result in fewer funds for banks to make loans to homebuyers. In turn, rates may increase, affecting millions of Americans if Fannie Mae scales back its mortgage purchases and is forced to pay higher rates on its approximately $1 trillion in debt held by investors. Outlook Record oil prices and other inflationary factors will cause the Federal Reserve Open Market Committee (FOMC) to raise the fed funds rate in the future. It appears that as fed funds rates rise, short-term yields will rise while long-term Treasury yields continue to simultaneously fall as the long run economic outlook appears uncertain and dismal. Rising short-term rates and the uncertain long run economic outlook will likely cause the flattening of the yield curve. Disclaimer: Data and information is provided for informational purposes only, and is not intended for trading purposes. Neither R.W. Wentworth nor any of its data or content providers shall be liable for any errors or delays in the content, or for any actions taken in reliance thereon.