Inverted Yield Curve Jude Wanniski February 1, 2000

We often find Gretchen Morgenson's "MarketWatch" columns in the NYTimes a cut above the crowd's, but her argument today that Treasury is to blame for the inversion of the yield curve in the bond market is worth no higher than an "F" on our report card. Her thesis is that Treasury's program of buying up government bonds has caused a shortage of bonds with long maturities and thus has caused the 30-year bond to yield less than the 2-year note. The column is a valiant effort to rationalize the stupidity of a Fed policy that is (1) raising interest rates to (2) slow the economy to (3) fight inflation when the yield on the 30-year government bond is falling, telling us there ain't no inflation out there. (Which is what gold has been telling us since 1997.) When an inane Fed policy is constructed around the wishes of a Fed Chairman who has been beatified by the establishment and its media agents, even intelligent folks like Ms. Morgenson are forced to become sillier and sillier in their analytics. The ridiculous assumption that inflation is caused by too many people working leads to a logic that gets us to this crazy place. Here is what the buy-back thesis must ignore:

1. The buy-back (about $30 billion worth) is expected to be concentrated in older issues with higher coupons. But most of these have rallied less than the current on-the-run bond. The 8 3/4 bond due in 2020, for example, has gone from 6.93 to 6.64 (less than 30 bps), while the current 30-year has rallied 33 bps.

2. The Treasury announcement came on January 13; the long bond yield did not peak until a week later. It is not likely the market would have waited a week to rally on the announcement.

3. At this point, the 10-year also has inverted relative to the 5-year, and is within 3 bps of the 2-year, which is about where the 30-year was just before inverting late last week. There is no expectation that the Treasury is going to be buying bonds in the 10-year range.

4. The buy-back represents a relatively small portion of the debt that is being retired as a natural result of letting the surpluses run. In the past year, publicly held debt was reduced by about $100 billion, which obviously did nothing to keep yields from rising nearly 200 bps.

5. The bond rally also has corresponded with gold falling more than $6/ounce, below $283, and the dollar's forex value rising about 4%. The Fed's trade-weighted dollar index today is higher than at any time since 1986. This suggests that at least part of the rally can be explained by the strengthening of dollar purchasing power creating a highly attractive real-yield premium at these levels. The yield curve inversion -- and it will stay inverted until our central bank announces its stupid experiment has come to an end -- soon could be causing big problems for the legion of Greenspan supporters in the banking system. Here, Ms. Morgenson provides a marvelous quote from Stan Jonas of Fimat U.S.A., a New York brokerage firm: "The real risk in the marketplace is a massive inverted yield curve for a long time." By raising rates, says Jonas, "the Fed may invert the yield curve even further with short-term rates escalating while yields on longer-term issues continue to fall. "This," he notes, "would be good for pensioners, but bad for people with adjustable mortgages. And it would kill the banks." After all, how long can banks stay in business by borrowing money at high short-term interest rates and lending it out at lower long-term rates? We await the Fed's announcement tomorrow of a 25 bp hike in the fed funds rate and its new method of assessing the future risk of too many people working. We can then try to guess how massively the yield curve has to invert for the central bank to bankrupt the banks. Once the pain gets too great and the Fed calls off the inflation dogs, the inversion quickly would end.

P.S. A student at my "Supply Side University" recently asked why the yield curve would invert anyway. I answered in part: "The yield curve inverts when the market senses that the Federal Reserve is not going to be as ‘tight' in the future as it seemed the day before. The market always is having to assess the intentions of the central bank...which is why the yield curve never inverted when the Fed had to maintain the gold price. The reason for the inversion is due to the fact that there are two components to a ‘bond.' One is its interest-rate component, the other its capital-gains component. Let us say the interest rate on the long bond is high, say 6.75%, because the Fed is fighting ‘inflation' with a high overnight interest rate, say 5.5%. Let us also say the rate structure in the futures market suggests the Fed will raise the overnight rate by 75 basis points to 6.25%. If the overnight rate is going to be 6.25% and the 30-year-bond 6.75%, the yield curve is as flat as a pancake. Then let us say the market begins to get information not readily available to most of us, but to a few, that the Fed only may raise the overnight rate by 50 basis points in the future. This tells the market that the 6.75% rate will have to come down, and the 10 year-rate will come down as well. This is where capital gains comes in. If you observe a 30-year bond with a 6.75% yield and know (or bet) that yield will soon be coming down, you can lock it in. FOR 30 YEARS!!! If you observe the 10-year bond and know it will be coming down, you can also lock it in, BUT ONLY FOR 10 YEARS. Your capital gain is limited by the bond's DURATION. The 30-year bond becomes more attractive than the 10-year bond."