Friday, May 29, 2009

Why Did the Yield Curve Invert Before This Recession?

Over at Free Exchange the inversion of the Treasury yield curve prior to this current recession is being interpreted as the result of a decline in the term premium, not a change in the expectation of future short-term interest rates. Specifically, the term premium allegedly declined for the following reasons:
Implicit inflation targeting appeared to be working; high and unpredictable inflation was relegated to emerging markets. That decreased the premium on long-dated government bonds. The savings glut also lowered long-term yields by increasing the demand for long-term governments, lowering their yields.
There are studies supporting this interpretation, but I am not convinced it is the entire story. For starters, if a belief in price stability led to a decline in the term premium, why did it suddenly kick in a few years ago? The Fed has had inflation-fighting credibility for several decades now so what makes the mid-2000s so special? Another problem with this interpretation is that the inverting of the yield curve was a global phenomenon. The above interpretation cannot explain why it was global. The saving glut was a regional one and its destination was regional too. At best, then, it could only have affected regional interest rates.

A more straightforward interpretation is that bond markets across the globe were sizing up the economic imbalances and foresaw the current global recession. As a result, they expected monetary authorities to cut future short-term rates across the globe and priced it into long-term interest rates. Now this is purely conjecture on my part, but I know of at least one study that provides evidence consistent with this view for the United States. Joshua Rosenberg and Samuel Maurer in a New York Fed study decompose the yield curve spread into its (1) interest rate expectations and (2) term premium components. What they find can be seen in the following figure where the gray columns denote recessions: (click on figure to enlarge.)

This figure reveals that for the United States the inverted yield curve prior to this recession was mostly the result of changes in the interest rate expectations component rather than the term premium component.

1 comment:

  1. Can you list the factors that contribute to the inversion of the yield curve?