Interest Rate Yield Curve

Interest rates on the shortest-term bonds correlate very closely with the interest rates set by the Federal Reserve Board. Long-term interest rates, by contrast, are influenced by many more factors, ranging from China's purchase of debt to investors' optimism about inflation and growth. Interested readers are refered to Comment 23 on our website and the graph contained there. We measure the yield difference as the difference between the Federal Funds rate and 10 year T. Interest rates are trending lower everywhere throughout the developed world.

Interestingly, despite the change in trend in the yield curve, short term interest rates continued to track lower (i.e., increasing Fed accommodation) throughout this period. The other 9 times where the trend in the yield curve was broken generally saw sharp sells offs (6 instances) or backing and filling in prices. Interestingly, however, the current flattening of the yield curve is telling us that "financial velocity" (willingness to take on risk) is about to decrease! Combined with a world of declining liquidity, then you have a recipe for disaster going forward. Interestingly, the market also does poorly when the yield curve is at its steepest. At 286 basis points, the S&P 500 starts falling.

Economists and investors believe that the shape of the yield curve reflects the market's future expectation for interest rates and the conditions for monetary policy. Economists are predicting that the FOMC has only a few moves left before it will stop tightening in this current cycle. Some economists predict that by year-end the FOMC will increase the Fed Funds target to 5.75, as this tightening cycle is finally expected to slow the economy at that Fed Funds target level. Economic figures have to be interpreted. Now many people would see these rates as stimulating output and hence GDP.

Economists from the University of Virginia estimate that if foreigners had not accumulated any US bonds over the 12 months ended May 2005, the 10-year yield would be 150 basis points higher. Economists use the yield curve to gage the overall movement in interest rates. The yield on a bond is based on both the purchase price of the bond and the interest, or coupon, payments received. Economic shocks have been muted in market effect. Also, economic shocks have been increasingly muted in economic effect for 25 years and especially again these last 10 years.

Long-term rates may be subdued, because the market anticipates a recession that will eventually force the Fed to loosen monetary policy. But short-term rates remain high, because the Fed has yet to act on what the bond market foresees. Long-term maturities usually have higher yields than short-term ones; this is seen as a normal yield. As this is the norm, it is shown on the chart as a positive slope. Long-term maturities are now paying a lower interest rate than short-term maturities.

Long-term interest rates are generally higher than short-term rates, resulting in a yield curve that slopes upward. An upward-sloping yield curve was in place in fall 2001 when six-month Treasury bills were yielding 2% at the same time that 30-year Treasury bonds were selling to yield slightly over 5%.