Wednesday, March 01, 2006

Toward Full Yield Curve Inversion

In its continuing coverage of potential indicators of future performance of the U.S. economy, The Dark Wraith Forums has featured the state and movements of the yield curve, which has been flattening considerably over the past months. The yield curve measures the term to maturity of various government Treasury instruments against their yields. The full story of why this happens and what it means can be found in The Dark Wraith Forums article, "Of Crystal Balls and Yield Curves," where it was noted that the past five recessions have been forewarned by an "inverted" yield curve, arguably making it the most accurate intermediate-range predictor of economic downturns, although in several instances the yield curve has inverted without a full-blown recession following.

An inverted yield curve occurs when long-term Treasury debt yields are lower than short-term yields. Normally, as the term to maturity of bonds lengthens, the yields they provide investors increase, thereby making a graphical representation of maturities of bonds against their yields a smoothly upward-arcing curve. A fully inverted yield displays the opposite behavior: the curve arcs downward from left to right. During a volatile period as the economy moves from relative health to a stage where a recession could come, the yield curve can display "partial inversion," wherein the curve arcs upward for very short-term to short-term yields, then perversely downward from left to right over the short- to intermediate-term bond maturities before recovering the normal, upward-arcing shape from intermediate- to long-term maturities of the bonds being tracked.

In the article, "Yield Curves 2005," published here, the yield curves at the beginning and end of last year were featured. The main graphic from that article is presented below.

In the graphic above, the purple yield curve for the first trading day of last year displays the classic, upward arc; by the last trading day of 2005, however, the yield curve had dramatically flattened and partially inverted, warning investors and government economic planners of a possible full inversion and the potential for a subsequent recession.

In the January 18, 2006, article entitled, "Yield Curve Inversion 2006," here at The Dark Wraith Forums, the progress of the partial inversion was shown: at that date, the yield curve was displaying a troubling, classic partial inversion, looking like a roller coaster with very short-term to short-term yields rising smoothly, short-term to intermediate-term yields falling precipitously, then intermediate-term to long-term yields again rising.

Based upon data provided by the United States Department of the Treasury, the graphic below presents the yield curve as of the end of trading on the last day of February, 2006. The yield curve from the January 18, 2006, article and the yield curve at February 1 are included for comparative reference.

The blue curve of January 18, 2006, was partially inverted: the intermediate-term to long-term yields were still rising, with the 20-year Treasury bond continuing to offer investors a better return than any short-term Treasury instrument. By the first day of February, that was still the case, but the entire curve had shifted upward as interest rates on all maturities had risen. By the end of February, the curve had generally shifted even further up, but the 20-year Treasury bond yield had begun to sag noticeably.

Using the peak yield, which has been at the 6-month Treasury note, as the base for comparisons, the spread between it and the 20-year Treasury bill yield for the three curves is as follows (one basis point is one one-hundredth of a percent):

  • January 18, 2006
    6-month T-bill: 4.46% 20-year T-bond: 4.58% Yield spread: 12 basis points

  • February 1, 2006
    6-month T-bill: 4.60% 20-year T-bond: 4.77% Yield spread: 17 basis points

  • February 28, 2006
    6-month T-bill: 4.74% 20-year T-bond: 4.70% Yield spread: —4 basis points

  • In other words, by the end of February, the 20-year Treasury bond yield had finally fallen below the yield on a mere 6-month T-bill. At this point, only parts of the curve remain non-inverted: in the range of the very short-term, 1-month and 3-month T-bills, which may persist for a while at slightly lower rates for technical reasons; and narrowly in the 5-year to 10-year range. For all intents and purposes, however, as of February 28, 2006, the yield curve had nearly fully inverted; and while the dynamic of the curve had been moving in this direction for months, the Bush Administration and its Republican allies who control the Congress continued to press their claim that the economic policies of tax cuts biased toward the wealthy coupled with deficit spending on war of opportunity at the sacrifice of major cuts in domestic programs was correct policy.

    With yet another near-record federal budget deficit now predicted for this year, the government would have little room to provide counter-cyclical fiscal stimulus directed toward middle-class and working poor households and small business; and even if the Republicans who control the federal government were to radically alter their priorities away from their natural base of support in large corporations and the wealthiest people, any counter-cyclical policies enacted now would have their effect felt far too late to stave off what could be a severe recession starting near the end of this year or early next year.

    The Dark Wraith Forums will deliver continuing coverage on the yield curve as its deepening inversion becomes evident even to the most dull-witted of the incompetent neo-conservatives.

    This article is cross-posted from The Dark Wraith Forums.

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