Study of Inverted and Flat Yield Curves

Since 1977, there have been 5 inverted curves and 1 flat curve. On average, these anomalies persist for 13 months, with 20 months being the longest period. Many “experts” on Wall Street predicted easing by the Fed and lower short term rates by year-end 2006, yet another example of the complete inability of anyone to correctly and consistently forecast interest rates (for more on this subject see 1/11/07 Wall Street Journal, opinion piece by James Grant).

Three of the 6 times, the curve regained a positive slope through rate declines, so the investor in short maturities was exposed to reinvestment risk while the investor in intermediate maturities enjoyed the prospect of capital gains and a “locked in” coupon or purchase yield.

The chart below presents 2 recent yield curves. On December 31, 2007, prior to the disruption that occurred over the ensuring 12 months, the yield curve was essentially flat from 3-months to 10-years. After the FED aggressively cut the Fed Funds target rate to 0-1/4%, or approximatley 3-1/2%, the 10-year rate had declined by approximately 50 basis points. They yield curve, which has averaged 140 basis point spread between 2- year and 10-year yields, now is approximately twice that, continuing to offer a compelling agrument for maintaining an intermediate maturity in a fixed income portfolio.

In June 2004, the FED began to aggressively increase interest rates. By the end of 2005, the yield on the 3- month Bill had increased by more than 1.5%. Again, the FED’s actions had limited impact on the 10-year Note, which increased in yield by only 20 basis points during that period and was lower than where it traded when the FED began to increase rates! During 2004 and 2005, the investor who maintained his intermediate investment grade corporate bond position earned a total return of 6.43% (CAM’s return) versus the 3-month Bill return of 2.24%. In 2006 the 3-month bill finally “won” returning 4.86% versus CAM’s 4.26%. But over the cycle, going short was a poor strategy.

The FED began cutting rates in mid-2007 in the face of the economic slow-down that later became the current recession. The yield curve steepened through 2007, became steeper during 2008 and arrived at historically wide spreads (2-10 years) during 2010.

Source: Barclays

 

FusionCharts.

Does the Fed Impact all Markets?

When the FED adjusts the Fed Funds target rate, the natural assumption is that most markets react in unison. The correlation triangle below refutes that assumption. Over the past 27 years, which has encompassed several cycles of FED increases and decreases, the 30-day U.S. Treasury Bill, a proxy for FED action, has exhibited no correlation with other asset categories. U.S. Intermediate GovernmentBonds and the Barclays Aggregate Bond Index both have correlations of 0.06, while High Yield Bonds have a 0.04 correlation.