Yield Curves 2005
A yield curve plots on the horizontal axis the term to maturity of select U.S. Treasury debt instruments and on the vertical axis their associated yields. A yield on a bond is the effective interest rate its holder earns, given the price of the bond, any coupons (periodic payments) provided, and the face value of the instrument.
Before discussing the yield curves, a brief introduction to bonds will help clarify the meaning of the term "yield." The easiest instrument to use is a one-year Treasury bill. The concept of yield extends from this debt security to other types in an entirely straight-forward manner.
Technically speaking, money is borrowed when a lender buys a promise from a borrower. The promise is usually embodied in a piece of paper called a bill, a note, or bond, the particular name generally being associated with the term to maturity of the loan: a short-term loan is contracted through the bill; an intermediate-term instrument is contracted through the note, and a long-term instrument is contracted through the bond.
Most of the time, these terms are used quite strictly in financial markets. For example, when a person gets a notice that he or she owes money, that person might say, "I got a bill." This is a common use that carries the underlying implication that the obligation represented by the notice is due pretty soon. On the other hand, a person planning for retirement might buy some kind of corporate or government bond, which means the obligation will come due in quite a few years.
Along the way, most bonds and notes pay coupons, which is to say that they periodically pay interest on the face value of the debt instrument. The coupon payment is usually stated in the original agreement as a percentage of that face value, which for corporate and government debt obligations is usually $1,000. So, a bond might carry a coupon rate of, say, 5½%, meaning that, every year, the holder of the bond will get a check for 5½%×$1,000, or $55.00, until the bond matures, at which time the holder will receive the face value of the bond, $1,000, plus one last interest payment. (In reality, most bond issuers make the payments semi-annually, or perhaps on some other schedule; so in the preceding example, the bondholder would most likely get an interest check for $27.50 every six months.)
The problem is that the coupon rate isn't the same as the yield on a bond because the prevailing interest rates in the market might vary from the rate of the coupon. Think about it this way: suppose you were holding a bond that had a coupon rate of 6%. At the time you purchased it from the issuer, that was exactly the interest rate on instruments of similar risk. But what happens if interest rates on similar-risk instruments being issued later go up to, say, 8%? You're stuck getting coupons at 6%. If you decide you want to dump this dog, you'll discover that the financial markets don't want it either. When the prevailing interest rate environment was at 6%, that bond was selling for exactly $1,000 (it was selling at par of $1,000), and this was because the 6% coupon payments would exactly service the debt over its life. But now that your bond is paying a below-market interest rate, no one's going to pay you $1,000 for it anymore. In fact, to unload the bond, you'll have to sell it at a discount (to par). In other words, the financial markets adjust the prices of bonds, notes, and bills over their terms to maturity to reflect how their interest rates are comporting with the prevailing interest rate environment. Going back for a moment to the example of that 6% bond, if prevailing interest rates had fallen to 4%, you'd have a bonanza on your hands: the financial markets would have to offer you a premium (again, to par) to have any hope of inducing you to sell your bond before it matures.
The way the price of a bond, note, or bill comports with its stream of coupon payments and its face value (the payoff at the end) determines the yield on the bond. Now, when coupon payments are involved, calculating the yield is a lot like work, but financial calculators and spreadsheet applications can do it without even batting an eye. The essential idea, however, is contained in debt obligations that don't have coupon payments. These are called "discount" instruments; and the way they work is that the lender buys the debt instrument from the issuer at some price considerably less than the $1,000 face value, then he or she gets the $1,000 at the date of maturity. In other words, the difference between what the lender pays and the one thousand dollars is the total interest the lender earns. This is how one-year Treasury bills work: an investor buys one for less than a thousand bucks, then gets a thousand bucks a year later. This makes the yield on the instrument pretty easy to calculate.
Let's take two examples. First, let's suppose that an investor buys a one-year Treasury bill from the United States government for $965.00. This means that the investor is lending the federal government $965.00 for exactly one year, at the end of which time the government must return to that lender the sum of a grand. Here's how to get the yield: the lender kicked in $965.00 and got back $1,000.00, which means the lender earned $35.00 of interest on a loan of $965.00. The interest rate earned is, then,
This 3.63% is the yield on that 1-year Treasury bill.
Here's the second example: the same scenario as the first, except that, this time, the investor buys the one-year Treasury bill for $950.00. The investor is still going to receive $1,000 in exactly a year, but he or she didn't have to fork over as much money. In this case, the lender kicked in $950.00 and got back $1,000.00, which means the lender earned $50.00 on a loan of $950.00. The interest rate earned this time is, then,
So this time, the yield is 5.26%.
Notice that the yield on a debt instrument is inversely related to its price: the less that is paid for a security, the higher the yield (or the higher the expected return when it's some kind of security that isn't such a sure thing like bonds).
This is a hugely important, fundamental concept in finance: the lower the price, the higher the expected yield; the higher the price, the lower the expected yield.
Now, moving on to yield curves, which is the topic of this article, every debt instrument has a yield. Government bills, notes, and bonds are the bedrock debt instruments upon which the interest rates of the economy are to some extent driven. A yield curve is a plot of the terms to maturity against the yields of various maturities of government obligations. Short-term government debt instrumentswhat are usually called "T-bills" for shorthave lower yields than intermediate-term debt instruments, which in turm usually have lower yields than the long-term debt instruments. This has mostly to do with the fact that, in normal economic times, investors need more inducement to lend money for a long time than for a short time. In other words, investors demand a higher interest rate on money they have to give up for, say, 20 years versus money they have give up for only a year.
Thus, in those "normal economic times" noted somewhat wistfully above, a yield curve should have a nice, upward arch to it.
Below are the yield curves for the first day of trading of 2005 (purple) and for the last day of trading for 2005 (light blue).
As is evident from the graphic above, the yield curve flattened dramatically during 2005. At the beginning of the year, it had a shape very typical of yield curves for the U.S. economy during periods of growth. By the end of the year, however, it had flattened and was approaching what is called an inverted yield curve, wherein the yields on Treasury instruments of long maturities are lower than yields on short maturity instruments. As was explained in detail in the article, "Of Crystal Balls and Yield Curves," each of the past five recessions in the United States has been preceded by an inverted yield curve. The causal link between an inverted yield curve and a subsequent recession is the steepening cost of shorter-term capital to businesses and households, which face higher rates of borrowing on everything from inventory to durable goods as interest rates rise. In fact, even though the rates on the very longest Treasury instruments dropped slightly from the beginning to the end of the year, this did not translate into particularly lower rates on loans like long-term, fixed-rate mortgages.
Adding to the difficulties facing some consumers, adjustable rate mortgages are frequently tied to the rate on a short-term Treasury instrument or index of instruments. As rates on such government debt rose through 2005, the rates being paid by homeowners with adjustable rate mortgages went nearly in step, meaning higher monthly payments for such mortgagees, who would then have less free income net of their mortgage payments for other purchases. The graphic below, derived from data provided in the Freddie Mac Weekly Primary Mortgage Market Survey, shows the path of fixed and adjustable rate mortgages for 2005.
Returning to the issue of changes during 2005 in yields on government debt instruments, the graphic at left presents the percentage rate changes for the various Treasury instruments' maturities presented in the first graph, above. For example, at the beginning of 2005, the yield on a Treasury security with one month to maturity was 1.99%, but by the last day of regular trading for the year, the yield on that same instrument had risen to 4.01%, representing a stunning change of (4.01-1.99)÷1.99=+102%, meaning that the rate on the shortest Treasury instrument more than doubled (i.e., rose by more than 100%) from the beginning to the end of the year. In fact, all rates but that on the longest Treasury bond rose: that 20-year bond fell, but only by a very modest 5 percent. The table below presents the data used for the yield graphics presented in this article.
The conclusion is that the policies of the Bush Administration, despite continuing reports of robust overall economic growth, have led to long-term losses for index portfolions in the U.S. stock markets and are now on the verge of producing a recession some time in the current year. The timing, severity, and length of this possible recession are a matter that may be analyzed in future articles here at The Dark Wraith Forums, but the yield curve as it now stands is a significant warning that neo-conservative economics is moving the United States to the brink of an economic downturn. This recession would be occurring in an era when the federal government, which since the time of Franklin Delano Roosevelt had used both fiscal and monetary counter-cyclical policies to soften the blows of recessions on ordinary citizens, is no longer willing or able to use vast resources of the government to swiftly pull the economy out of the clutches of a downward economic spiral.
The only comfort comes from the fact that any impending recession will likely begin to reveal itself before the 2006 mid-term elections, at which time a number of those who found the Republicans so worthy of being allowed to control not just the Presidency but also both Houses of Congress may finally be unwilling to return to office those from a political party so prone to corruption, mean-spiritedness, and downright incompetence.
The Dark Wraith can only hope for such a silver lining in what is otherwise a looming, bleak economic period for the country.