The big news in the bond market is the expected imminent ‘inversion’ of the yield curve. An inverted yield curve is one in which the yield on long term bonds is less than the yield on short term bonds.

The Financial Times, on 09-Feb-2006, published an analysis by Jennifer Hughes about the inverted yield curve, entitled, “A world turned insider out: why investors are re-evaluating the predictive power of bonds.”

This article sums up fairly well the diverging views on this subject, some consistent with Capital Flow Analysis, some not, without coming down on any side.

This brings us to the question, how should an inverted yield curve by viewed by a capital flow analyst?

The answer is: With much circumspection.

The Rationality Trap

One common error in market analysis is, what I call, the ‘Rationality Trap’. Here are two symptoms that indicate that an analyst has fallen into this unfortunate way of thinking:

1. The analyst assumes the all investors behave as ‘rational men’, according to the analyst’s definition of rationality’; or

2. The analyst assumes that prices are determined only by investors (disregarding issuers) and that all investors have similar motivation.

In the Financial Times article, there is a classic example of the “Rationality Trap”, that reflects a commonly held view:

“Normally the yield curve slopes upward. This makes sense as investors would be expected to require a higher yield to compensate them for the greater risk and uncertainty of investing over a longer term.”

From this the analyst concludes that an inverted yield curve is unstable and must eventually go away, either by increasing long-term rates, or by a drop in short-term rates, as investors switch between long and short-term paper.

Those who fall into the “Rationality Trap” don’t believe in the “Irrationality Axiom“, a basic principle of Capital Flow Analysis.

Another View of The Yield Curve

There is another way to look at the yield curve, which, it seems to me, is more realistic than presuming that investors hop willy-nilly from long-term to short-term positions based on a common view of risk-reward and the desire to ‘maximize returns’.

This view is simply that long-term rates are determined by one market, with one set of players, while short-term rates are determined by another market, with another set of players. There may be some overlap, but not necessarily.

For example, let us imagine a simple market made up only of three players:

1. Households: Individuals who put short-term money in money market funds and who buy fixed annuities when they retire.

2. Insurance Companies: Corporations that sell fixed annuities to individual investors.

3. Money Market Fund Managers: Corporations that sell money market fund shares to individuals.

Obviously, if short-term rates exceed long-term rates, individuals will not stop buying annuities and start buying money market funds. These are two entirely different products with different purposes.

The insurance company is intent on the spread between the amount charged the investor for the annuity and the rate on long-term bonds held to portfolio to back up commitments to purchasers of annuities. The insurance company is not going to sell bonds in portfolio to suddenly switch to thirty day paper for higher yield, because, should the rates change again, which is almost certain, the insurer might not be able to satisfy commitments to holders of annuities and could go bankrupt.

In the same sense, the manager of the money market fund is not going to jump into long-term bonds when long-term rates soar, because to do so would jeopardize the fund’s ability to maintain a stable net asset value when interest rates change again.

The real world, as this site reveals, is more complicated that a simple three player market.

(See: “The Big Picture“)

There are many players, each dancing to a different tune. The market is not limited to only long-term and short-term investors, but there are other players in the intermediary segments. Capital Flow Analysis tries to understand the interplay between many different market segments, although this is not easy to do.

It seems obvious, to me at least, that interest rates are not determined by a single type of player who switches from long to short term paper and back again, with each shift in rates.

Under the ’separate market’ scenario, it is likely that an inverted yield curve will just go away in the normal course of events, simply because long-term and short-term markets operate under different rules, exhibiting distinct behavior patterns.

One should not conclude that an inverted yield curve is inherently unstable, just because it comes and goes from time to time. This may be coincidence.

This Is Not Your Father’s Market

Another common fallacy that involves the inverted yield curve is the claim that by observing past behavior of the yield curve, as related to the business cycle, reliable predictions regarding the next business cycle can be made.

The Financial Times article had this to say,

“An inversion of three-month and 10-year bonds has preceded each of the last six recessions. … Recessions tend to lag an inversion by four or five quarters … When the yield curve inverts … it implies investors believe growth will slow and inflationary pressures will weaken. … Investors are betting on recession.”

The problem with this line of thinking is that the capital market is evolving. Today’s players and institutions are not those of yesterday. This is not your father’s market.

Unless one can show why a past recession was caused by, or otherwise linked to, an inverted yield curve, and the precise cause and effect mechanism that led to economic change, and then demonstrate that the same conditions exist today, it would seem wiser to avoid the mysticism of ‘chart reading’ in predicting business cycles.

World capital markets are changing so rapidly, with new institutions being invented, effecting prices, that conclusions based on past markets and past institutional structures seem precarious.

As the Brazilians say, “O cu nada tem com as calças.”

This entry was posted on Friday, February 10th, 2006 at 1:56 pm and is filed under Capital Flow Analysis, Treasuries, Open Market, Agencies, Mortgages, Municipals, Corporate Bonds. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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