Happy Canada Day! I do not have a lot of time to look at new topics, but I saw an article about the Treasury curve that triggered a desire to drop a comment.
The above figure shows the slopes at the front end of the Treasury yield curve. Specifically, the black line shows the 2-year yield less the 3-month bill rate, and the red shows the 2-/10-year slope. The current situation is somewhat unusual in that the 3-month/2-year slope is mildly inverted, while the 2-/10-year slope is mildly positive.
The interpretation of this is straightforward: the discounted path of forward rates implies a few cuts within a 2-year forecast horizon, but we would then have discounted rate hikes over a 10-year horizon assuming no risk premia, or a flat curve if we add in a mild term premium for the 10-year versus the 2-year (which is my default assumption, whacky affine term structure models to the contrary).
For believers in the “yield curve inversion predicts recessions” theory, this means that the choice of the short leg of “the yield curve” is critical. If one uses the 2-year maturity, then recession risks have allegedly abated due to the dis-inversion of the curve. However, if one uses the 3-month point, then we are still in “recession risk” territory (although less than earlier).
One concern with using the 3-month rate is that it is very tightly locked to the administered overnight rate, and so it cannot be described as true “market” rate in this context. We need to think of it as “the market thinks the Fed is wrong.” (I also tend to ignore the 3-month tenor in my analysis since something like the 3-month bill/10-year Treasury is not a remotely trade-able cash combination; if you want to mess around with money market maturities (and you are not — thank your lucky stars — a money market fund manager), you need to use more exciting derivatives.
My interpretation of the curve is that it is the result of a tug of war between market participants with heavily divergent views. Taken literally, the curve implies that the Fed is making a mistake and will cut rates. But the Fed will then turn around and realise that everything is hunky-dory and will stop after just a few cuts. Although such tactical rate cuts are theoretically sensible, such outcomes tend to be rare — it is a lot simpler for the central bank to just sit on its hands and leave the policy rate flat. Instead, I think the situation is that the economic pessimists are positioning for lower rates in the near run, while the investors who are concerned about longer-term inflation risks (which will catch the Fed’s eye, even if President Trump whines) are more comfortable with steepening positions further along the curve.
Email subscription: Go to https://bondeconomics.substack.com/
(c) Brian Romanchuk 2024
