Strange Curves: What Explains All the Negative Yields?

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These are strange times in the financial world, even by the standards of these past five years. It is not every day that you see negative yields spread in country after country throughout a good proportion of Northern Europe. At the same time, it is highly unusual to see those negative yields extend down respective yield curves so far. The Swiss 5-year, for example, has been trading in and out of negative yields since June 12, meaning for the past six weeks investors have been buying 5-year paper for no return. That is extraordinary to me, and I think it conveys a lot of information about general liquidity conditions in the banking system and the largely hidden flow of money. More importantly, though, these kinds of credit oddities may be trying to convey important information about expectations for the next decade.

As of yesterday, the German yield curve was slightly negative all the way to a maturity of 3-years, with a 4-year yield at only 9 basis points. There is not much slope to the curve from there, but it is at least positive. The 10-year is at 1.22%; while all the way out to 30-years is just barely above 2%. In basic financial terms, that means investors are receiving only about 80 additional basis points of yield to take on 20 extra years of risk. That risk involves what most would consider low probability events, such as a German default. That spread also contains the risk of high inflation, which is likewise being discounted heavily. However, this very flat yield curve is also conveying investor expectations that the risk of "normal" inflation or a more "natural" yield curve is also next to nothing.

Before settling on that interpretation, though, it is useful to compare those rates with systems where money is not so plentiful. In contrast to the German 2-year bund yield of -0.05%, the Spanish 2-year yield is around 5.2%, while the Italian 2-year is trading near 3.65%. At the 10-year maturity, Germany sees a yield of 1.22%, while Spain shows 7%, and 5.3% for Italy. To get an idea of the extreme, Portuguese government 2-year bonds yield about 8% (yields traded widely yesterday), while Portuguese 10-year instruments trade around 10.25%.

The perceived default risk is striking in the contrasting spreads of peripheral bonds over German bunds. At the 2-year maturity, the spreads for Italy, Spain and Portugal are 3.7%, 5.25% and 8.05%, respectively. At the 10-year maturity, the spreads for Italy, Spain and Portugal are 4.08%, 5.78% and 9.03%, respectively. These spreads convey rather neatly the perceived credit risks embedded with these "unnatural" bond yields. So it is no surprise that money is flowing away from the higher yield, high spread nations toward the perceived strength of "core" nations.

Inside each national system, however, there is another story altogether cleaved from perceived default risk. The spread between the 2-year maturity and 10-year maturity for Germany, Italy, Spain and Portugal are 1.27%, 1.65%, 1.8% and 2.25%, respectively. In other words, the yield curves in each nation, irrespective of perceived credit quality, are relatively flat. This is not a new development for PIIGS debt, as their respective curves have been differing degrees of flat for some time now. By contrast, in May 2010, the German 2-10 spread was about 237 basis points, or more than 1% greater than currently. That may not seem like a large change, but in terms of credit spreads it is immense.

That trend extends to the United States Treasury curve as well. Going back to just July of last year, the 2-10 spread has compressed (flattened) from more than 260 basis points to about 125 basis points currently - a move far greater than Germany. In terms of shape, the US yield curve looks very much like Germany's - only a slight upward slope in the front end as yields are uniformly below 1% all the way to 7-years. For the most part, these yields on treasury notes are record lows.

As a comparison, throughout the first half of 2006, the US Treasury yield curve compressed markedly as the tail-end of the Federal Reserve's "tightening" regime pushed short-term interest rates up from their then historic lows. In January of that year, the 2-10 spread was 0%. In fact, there was a slight inversion of yields between the 6-month bill and the 2-year note (a -6 basis point spread), but the spread between the 1-month bill and 2-year note was significant at nearly 30 basis points. By June 2006, the 2-10 spread was still 0% even though overall nominal yields had risen at both ends by about 80 basis points. The 6-month bill inversion remained, as did the positive slope with the 1-month bill (which had steepened by another 20 basis points). In other words, nearly the entire curve shifted uniformly higher as anxiety over the Fed's tightening actions in Fed funds waned slightly. Credit investors were demanding a slightly higher yield to invest across the treasury curve because a consensus had been forming of a continued "boom" despite the monetary change.

Only a month later, in July 2006, the entire yield curve had gone entirely flat, with a very slight inversion at the front end. By the end of November 2006, nominal yields on the longer-end of the US curve had fallen by a nearly uniform 50 basis points, while the shorter end yields remained largely unchanged. The result was a full inversion: on November 30, 2006, the spread between the 1-month bill and the 10-year bond had reached -60 basis points. In other words, investors were asking for 0.6% more yield to own a US government security maturing in one month than an equivalent security maturing fifty-nine months further on.

That inverted curve persisted, more or less, all the way into September 2007, to the Fed's first emergency measures. In terms of conventional understanding, short-term risks were high enough that investors demanded more yield to lend at shorter durations. Longer-term investors reacted to cyclical expectations of typical central bank actions. They expected that any cyclical weakness would lead to a reversal of monetary tightening, therefore they rushed to lock in longer-term rates in advance of these expectations. Investors, more or less, were simply front-running expected central bank actions. But by and large, these expectations for central bank actions carried no permanence; they were entirely based on the proposition that cyclical weakness opened a temporary opportunity to outperform the expected trajectory of interest rates. If expectations were for anything other than cyclical or temporary weakness, interest rates would have reacted far more violently from the outset.

Consistently flat or flattening curves are different because money is supposed to have time value. Investors are supposed to demand greater potential rewards for tying up liquid money at longer maturities since inflation erodes proportionally greater value as time moves forward. The entire existence of the financial and banking systems depends on this fact of financial nature. The banking system's inherent carry trade is predicated on this ability to wring returns out of the time value of money. By borrowing over shorter durations and lending out at longer maturities, banks and financial agents aim to capture that time value. The downside of such a regime has always been the illiquidity of the longer-term assets and problems rolling over those short-term funding arrangements. This is a predicament that will likely never see resolution as long as the financial system exists in this time value world of positive carry.

The positive carry framework extends into the real economy as well. Businesses and individual savers themselves convert money into risky projects because of time value. The role interest rates play into conveying not only default and liquidity risks, but time value is vital in setting the course of real investment. If there is no potential return signaled by interest rates of a flat yield curve, there is no incentive for any business or investor to invest at longer maturities. This is problematic in the real economy because real productive investments are not short-term in nature. The climate for business investment is one in which companies need to be compensated for embarking on long-risk projects, and interest rate curves (especially the treasury curve in the US, unfortunately) play a huge role in setting that agenda.

As yield curves flatten, there is little to no distinction between borrowing or lending today and borrowing or lending in five or ten years. That's supposed to be a great bargain for borrowers (and this is what central banks would like to foster), but it does little for lenders. So what central bank policies produce are great conditions for borrowers (generically speaking), but put money and capital in the hands of agents that have weaker and weaker incentives to put that money to use as intended.

In an environment where nominal interest rates are relatively high, Portugal, Spain and Italy, for example, the lack of time value is indicative of investor avoidance due to credit risk. In other words, credit risk is high so it does not matter if someone wants to borrow at two years or ten years, marginal lenders will avoid these borrowers at any terms.

For nations with flat curves and very low nominal interest rates, the opposite does not hold. Despite the logical expectations of a reverse situation, lenders in a low nominal rate environment are not willing to lend any amount at any maturity. Instead, the flat yield curve in the low rate environment is pretty much the same condition as the flat yield curve in the high nominal environment. In both places, investors will be forced to choose investments based solely on credit quality, or, as in today's environment, liquidity opportunities. At almost every point on the curve, time value has been neglected or, more likely, displaced by some other factor.

The Federal Reserve and conventional economics is committed to the idea that money is neutral. That means that monetary policies and measured implementations of "stimulus" can have powerful impacts over the short-run, but have no impact on longer term "variables" in the real economy. I wholeheartedly reject this assertion, but for now we can set aside any argument for nonneutrality. The Federal Reserve's Zero Interest Rate Policy (ZIRP) was instituted in December 2008. As of earlier this year, it is current Fed policy to maintain ZIRP through the middle of 2014. This week, Chairman Bernanke hinted that ZIRP could be left in place for longer.

As of now, ZIRP has been in place for almost 44 months. Going back to the end of 2001, the Fed funds target has been below 2% for all but three and a half years of that nearly eleven-year period. Conclusively, the Federal Reserve has shown a overwhelming willingness to engage in monetary operations aimed at increasing the stock of money or decreasing the real rate of interest (or both) at any sign of potential dislocation, to an extreme. The Fed has been joined at times by the Bank of Japan and the People's Bank of China. It has been echoed by the Bank of England, and, especially recently, the European Central Bank. Might flattening yield curves be reflecting longer-term expectations of a never-ending liquidity trap?

By piling on liquidity measures globally, investors have taken these cues from central banks to combine expectations of economic weakness with liquidity preferences as new monetary measures further expunge time value from the system. As time value shrinks ever more, regardless of ultimate credit risk, investor expectations for still further "liquidity" measures diminishes the distinction of lending and investing over time. This cycle is reinforced even more by the inevitable failures of monetary measures to have an appreciable positive impact on real economic variables. That itself may be explained by what conventional economics at least admits of the neutrality of money. These monetary stimulations are decidedly not short-term in nature, and therefore, under the terms of conventional economics' own interpretations, have likely left the realm of neutrality. If monetary intrusion is only neutral in the short-run, even the most hardened monetarist will have to admit that we are well beyond that standard now.

As central banks get further and further away from their own perceptions of neutrality, they embed these distortions in money systems all over the globe. Investors, for their part, including the large multi-national banks themselves, get more and more "comfortable" with the idea that central banks will simply never give up these liquidity measures; therefore there is no time value left for investment. The only considerations left are credit risk and liquidity. So as much as any yield curve has any slope left in it, it makes sense to lock in rates now before they drop ever further toward zero.

Of course these expectations are further cemented by the lack of collateral available to financial agents, so one trend of expectations simply reinforces the other. I believe that is why, at present, you actually see flatter yield curves in the low nominal rate countries than the "high risk" PIIGS nations. Bond markets in these places are determining that central bank action is the primary risk moving forward, above default risk.

We can extend that interpretation out further to the possible conclusion that bond markets may actually be positioning for the possibility that central bank liquidity measures are themselves the condition that is keeping the investment climate in global credit at a compressed level. If flat curves are indeed pricing future expected interventions, we should see steepening curves if investors believed that they held a likely path to succeed at fostering real economic growth. That curves are flattening suggests that opposite expectation. Just like the inverted curve led to less violent interpretations of interest rate movements because of expectations for cyclicality, these near-zero, flat curves are suggesting a level of permanence to these credit expectations.

Is this the credit market equivalent of expectations for the Japanification of the developed world? That might be a bit extreme for now, but there is little doubt that constant liquidity and monetary intrusions are playing a role in these odd instances of credit curves. We know that directly since the Federal Reserve, in particular, is actively buying longer-term US Treasury bonds. But it is also selling short-dated government securities, the second part of Operation Twist, without having any appreciable impact there. In fact, the opposite is occurring - yields are not rising in the short end as policymakers expected given their selling pressure. Despite Fed selling in the shorter end, demand for US Treasuries has overwhelmed that selling pressure, leading to a near pancake of a short-term curve in the US; record low rates abound there.

While it is difficult to glean any "clean" conclusions from all these strange curves, it is, in my opinion, suggestive of an environment where credit markets have become resigned to intractable liquidity problems and the inevitable money stock measures that will be offered as a result, none of which will have any appreciable impact on the real economy, at least in a positive manner. That this is a global phenomenon that extends to expectations years into the future does not bode well. The good news, depending on your persuasions, may be that the stock market seems to be pricing the opposite conclusion, setting up a titanic battle of eventual convergence. Given that credit markets dwarf equity markets by an order of magnitude, however, I would not call stocks the favorite in this horse race.

 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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