Wednesday, August 29, 2007

The Yield Curve and the Flight to Safety

A new paper by Glenn Rudebusch and John Williams shows that the yield curve spread is a better predictor of recessions than are professional forecasters. This fact may explain why yield curve is not used as much one would expect by the professional forecastors--they are loathe to promote a simple metric that renders them obsolete.

Given this papers timing, it is interesting to consider what impact the flight to safety in treasury bills (and out of asset-backed commerical paper) over the past few weeks has had on the current yield curve. This first figure (from the FT) highlights this drop using the 3-month treasury bill yield. Here the drop appears to be part of a downward trend even as the federal funds rate, the anchor of the short term interest rates, is stable. Note how the federal funds rate and the 3-month treasury yield track each other closley up through the middle of 2007. Thereafter, the series break, presumably because of the flight to safety (see the oppossite response in the asset-backed commerical paper). So what does this all mean for the yield curve? Does this flight to safety add noise to the yield curve's predictive ability?

This next figure shows the journey of the treasury yield curve since the Federal Reserve started tightening in the summer of 2004--beginning a slow ascent from the bottomed-out 1% federal fund rate--and takes us to the beginning of August 2007. During this time the yield curve is flattening--the long end is not proportionally moving up, if at all, with the short end. One famous observer called these developments a a 'conundrum'. Others simply viewed these developments as the yield curve beginning to point to a slowing of growth or a recession. Based on the expectation theory (and assuming a stable term premium), the long rates should simply be an average of expected short rates and thus, the long rates should be a reflection of where short rates are expected to be going. If market participants expect slower growth ahead and in turn expect the Federal Reserve to respond by cutting its policy rate, then the long-term rates will decline. Consequently, the recent flattening of the yield curve, and its slight inversion at times, can reasonably be interepreted as an economic slowdown is looming.

Given where we are--slow real growth, housing recession, credit crunch, etc.--the yield curve's predictions appear to have been on the money. So now, I want to see what impact, if any, the flight to safety has had on the yield curve--has it added any noise? This next graph reproduces the treasury yield curve at the begnning of August 2007 as well as two subsequent days in this month: August 2oth, when the 1-month treasury yield hit is lowest value of the month, and August 28, the latest data point available as of this posting. What this figure shows is that the noise from the flight to safety appears to only to have had a temporary effect on the overall flatness of the yield curve. Yes, there was a drop in the short end of the yield curve as seen on August 20, but by August 28 the shape of the yield was almost identical to what it had been at the beginning of the month. The yield curve, then, appears capable of withstanding the occasional noise of a marekt panic. More importantly, however, is that the current, flat yield curve indicates we are not out of the woods yet.. hang in there!

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