About the yield curve
(Source: Man Financial) Let’s discuss Bernanke’s yield curve comments. Personally, I am interested in the debate because some of it is too academic and it has some important investment implications for those managing money. The flat yield curve is being blamed on a lower term risk premium due to lower inflation or some other factor such as central bank treasury demand.
Here’s the issue. An investor is faced with a choice of investing over the term structure of rates. Let’s use a 10 year investment horizon as an example. The investors can buy a 10 year note or invest in a 1 year note 10 times rolling each year to cover the exposure. Transaction costs are now cheaper than 20 years ago, so in theory it is cheaper or easier to roll the 1 year note 10 times, which could actually increase the appeal of the 1 year roll play compared to the outright 10 year – the 10 year is less attractive due to transaction costs. I believe capital will move to the best alternative over time, but investors can be wrong for extended time periods.
Right now, investors seem almost indifferent between the 2 options. This implies that the buyer of a 10 year thinks he/she will receive a return which is no worse than rolling the 1 year note ten times. Otherwise, why do the trade. This is especially true of a retail investor. This tends to imply either stable long term inflation expectations, lower future interest rate expectations, or some need to own long paper regardless of term structure issue – think pension liability (or the need to receive stable “high” rates for retirement).
Some combination of these three issues is at work and two of the three factors hint the economy will not develop runaway aggregate demand or generate inflation. I just cannot see the marginal investors locking up money for 10 years just because. In the past, curve inversions have tended to lead to a decline in interest rates and precede a bull markets in fixed income. The one caveat this time is the unusually low rates in Japan and the global issues created by China and India. The equilibrium interest rate equating savings to investment is lower than in the past. It is difficult to know what the curve means, and investors can be very wrong in their outlooks, but realize the factors at work.
The issue is not a conundrum or puzzle. The Fed and economists are just having troubling betting in public which factor is at work for fear of being wrong. Watch the Japanese 10 year closely as a sharp rise in yields in Japan may steepen the U.S. curve and help resolve the issue. Demographic issues in Japan have lifted global savings. If rates rise in Japan and the U.S. curve remains flat, there is likely to be economic trouble ahead.
Here’s the issue. An investor is faced with a choice of investing over the term structure of rates. Let’s use a 10 year investment horizon as an example. The investors can buy a 10 year note or invest in a 1 year note 10 times rolling each year to cover the exposure. Transaction costs are now cheaper than 20 years ago, so in theory it is cheaper or easier to roll the 1 year note 10 times, which could actually increase the appeal of the 1 year roll play compared to the outright 10 year – the 10 year is less attractive due to transaction costs. I believe capital will move to the best alternative over time, but investors can be wrong for extended time periods.
Right now, investors seem almost indifferent between the 2 options. This implies that the buyer of a 10 year thinks he/she will receive a return which is no worse than rolling the 1 year note ten times. Otherwise, why do the trade. This is especially true of a retail investor. This tends to imply either stable long term inflation expectations, lower future interest rate expectations, or some need to own long paper regardless of term structure issue – think pension liability (or the need to receive stable “high” rates for retirement).
Some combination of these three issues is at work and two of the three factors hint the economy will not develop runaway aggregate demand or generate inflation. I just cannot see the marginal investors locking up money for 10 years just because. In the past, curve inversions have tended to lead to a decline in interest rates and precede a bull markets in fixed income. The one caveat this time is the unusually low rates in Japan and the global issues created by China and India. The equilibrium interest rate equating savings to investment is lower than in the past. It is difficult to know what the curve means, and investors can be very wrong in their outlooks, but realize the factors at work.
The issue is not a conundrum or puzzle. The Fed and economists are just having troubling betting in public which factor is at work for fear of being wrong. Watch the Japanese 10 year closely as a sharp rise in yields in Japan may steepen the U.S. curve and help resolve the issue. Demographic issues in Japan have lifted global savings. If rates rise in Japan and the U.S. curve remains flat, there is likely to be economic trouble ahead.
posted by CODACap at
11:38 PM
0 Comments:
Post a Comment
<< Home