The great yield curve paradox

A steep yield curve is built on the concept that rising interest rates reflect rising demand for loanable funds and inflationary support — evidence of a robust economy. The trouble is that the yield curve is indeed steep at the moment, rising from almost zero at the short end to about 3% at the long end. This is a steeper yield curve than is seen during good times, when it rises from about 2% in the short term to 4.5% in 30 years.

The paradox is that this predictor, the yield curve, says “growth” while markets say “recession.”

Interest rates in the U.S. are about zero at the front end, 1.75% at the middle and 2.82% at 30 years. The Canadian yield curve starts at 0.8% at the front end, and reaches 2.02% for 10 years and 2.78% for 30 years. Ironically, the U.S. growth rate of real gross domestic product was 1% at the end of the second quarter of 2011, while Canada’s real GDP growth rate for the period was minus 0.4%. The fact yield curves ignore insipid growth in the U.S. and contraction in Canada shows the unreality of fixed-income markets.

“Today, the curve is of less use than it was in the past,” says Marc Stern, portfolio manager, vice president and head of discretionary wealth management with Industrial Alliance Securities Inc. in Montreal. “The economy is slowing, unemployment is rising, European banks are under pressure to raise capital and China looks to slow, too, which will all have negative effects on the Canadian economy.”

The short end of the yield curve is being held down by central banks’ policies — especially those of the U.S. Federal Reserve Board, which continues to keep the overnight price of money within a band of 0%-0.25%. The Fed’s recent move — dubbed the Twist — in which it swapped short-term bonds for long bonds, should flatten the curve a little. But the present yield curve, warped by government policy, is not reflective of what is ahead for the U.S. and Canadian economies, says Edward Jong, vice president and head of fixed-income with TriDelta Financial Partners Inc. in Toronto.

The yield curve would be flat — indicating no growth — were it not for the Fed’s actions to hold interest rates to near-zero levels, says Alan Clarke, European economist with Bank of Nova Scotia in London. The yield curve is likely to invert in the two- to 10-year range after the U.S. presidential election next November, he adds: “The yield curve, if adjusted for the U.S. government’s policy-induced zero short rates, tells us that there will be worse news before things get better. When the U.S. government decides to pay its bills and move toward austerity, that will reduce business growth and consumer spending, and further depress demand for money. That would lower interest rates even more. Inversion in the two- to 10-year range would then reflect financial reality.”

The yield curve needs to be reinterpreted. That’s where inflation adjustments come in. Says Tony Warzel, president and chief investment officer with Rival Capital Management Inc. in Winnipeg: “The curve is indeed steeply sloped, but that’s only for nominal returns, and it’s a curve that we have never seen before. If we drew the curve on real rates of return, we would have a downslope showing growing negative returns all the way out to almost 30 years.”

Fixed-income investors are quite capable of accepting low returns. Japan, which has had near-zero interest rates since the Nikkei 225 index peaked in 1991, has not seen a revival of its equities markets. But, out of fear of suffering worse than inflation erosion, Japanese households have stayed out of stocks.

Low interest rates, in other words, do not produce economic revival, Stern notes. In the U.S., two years of historically low rates have not been sufficient to restore economic growth.

In spite of the steepness of the yield curve, there is little inflation risk, says Stern: “Reduced demand for commodities should reduce headline inflation.”

Price spirals of the sort that drove interest rates in the U.S. and Canada to double-digit levels in 1982 are not foreseeable. With official unemployment numbers of 9.1% in the U.S. and 7.5% in Canada and substantial slack in the economy, wages are unlikely to push up prices.

Moreover, consumers are showing they would rather keep their money safe and their spending power intact. This means higher precautionary balances and reduced demand for loanable funds, all of which work to keep interest rates down.

The yield curve’s projection of a revival is false. You can reset the yield curve by taking central banks’ manipulation of short rates out. Raise the front end, and what is left is a sagging middle and some upslope after 10 years. That’s an inverted curve, which indicates that worse is still to come. IE