Interest rates allow investors to observe the state of the economy and, at the same time, are an instrument of monetary policy control.
The temporary interest rate structure (market interest rates at different maturities) is vital for the valuation of financial assets. It represents the relationship between the yield of bonds of the same credit quality with different maturities. They are built for U.S. Treasury bonds that have no credit risk or liquidity risk. They are considered the world’s safest securities (risk-free asset) because they are backed by the full faith and credit of the U.S. government. It can adopt different shapes, as the graph below shows:
As for the cause of the different shapes, there are several theories:
- The pure expectations theory implies long-term interest rates are simply unbiased reflections of the expectations of the markets of interest rates with short-term conditions. The theory implies there is no premium created on long-term interest rates to reflect a higher level of risk. The upward slope of the yield curve is not explained by a risk premium and must be reflected by future expected inflation rates. The fundamentals of this theory are found in Irving Fisher´s book, "The Theory of Interest," and John R. Hicks and Friedrich A. Lutz's paper, "The Structure of Interest Rates."
- The liquidity preference hypothesis is covered in Hicks’s book, “Income." He says investors prefer the short term and will only invest in the longer term in exchange for a premium. This will be greater as the maturity of the bond increases. The forward rate is a biased predictor of the spot rate, with the bias always positive and growing with the term.
- First introduced by economist J.M. Culbertson in his paper, "The Term Structure of Interest Rates," the segmented markets theory considers that the bond market is full of heterogeneous agents with different income needs. Therefore, investors in the bond market invest in different parts of the term structure based on their income needs. It assumes there is no global market of bonds, but the performance of them is determined in independent markets for each term. This theory has received less attention because the empirical evidence shows investors are willing to change the term of their investments for a premium.
- The preferred habitat theory was introduced by Franco Modigliani and Richard Sutch in the paper, "Innovations in Interest Rate Policy." It assumed risk aversion, so investors will only be willing to match the horizon of their investments with their habitat in exchange for compensation, a term premium.
Modern models attempt to quantify how rates evolve and capture future movements. For example, the Vasicek model is a financial model which describes the evolution of interest rates. It is a one-factor model, so interest rate movements are driven by only one source: the market risk. The Cox–Ingersoll–Ross model (or CIR model) in the paper, "A Theory Of The Term Structure Of Interest Rates," also describes the evolution of interest rates. It is another one-factor model and it is an extension of the Vasicek model, which was created by Oldrich Vasicek.
The yield curve is a plot of the yields on all Treasury maturities ranging from one-month bills to 30-year bonds. An upward slope indicates that bond investors expect to be compensated more for taking on the added risk of owning bonds with longer maturities, so a 30-year bond typically yields more than a one-month bill.
On the other hand, an inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. It is important because it is considered to be a predictor of economic recession. An inverted yield curve is sometimes referred to as a negative yield curve.
Historically, inversions of the yield curve have proceeded many U.S. recessions. Due to this correlation, the yield curve is often seen as an accurate forecast of the swings in the business cycle. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are demanded, sending the yields down.
Reviewing the history, I found that in the last nine recessions, the rate was always inverted:
The U.S. curve has inverted before each recession over the past 63 years. In other words, when short-term yields climb above longer-dated ones, it means short-term borrowing costs are more expensive than longer-term loan costs. They also influence the economy because they are the rates individuals and businesses pay to borrow money to buy real estate, vehicles and equipment.
Further, companies find it more expensive to fund their operations and consumer borrowing costs also rise, slowing spending, which accounts for more than two-thirds of the U.S. economy. So, the economy eventually contracts and unemployment rates rise.
Although the yield curve inversion has no power to predict the length or severity of a recession, it’s time to be cautious when investing in the stock market. The Standard & Poor's 500 (SPY, Financial) yields 15% on a year-to-date basis, so perhaps it is time to start shorting positions.
Disclosure: The author holds no positions in any securities mentioned.
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