Alan Greenspan publicly declared that the failure of long-term interest rates to rise meaningfully in the face of Fed tightening is a conundrum. The conventional wisdom is that the flattening of the yield curve takes place by both short and long-term interest rates moving higher, with short-term rates moving more rapidly. Does history prove this to be the case? Prior to early 1982 this was definitely so, but since 1982 the opposite has tended to occur.
To make my case I analyzed daily yield data for 3-month Treasury Bills and the 10-Year Treasury Constant Maturity from February 1, 1962 through April 4, 2005. I determined the steepness or flatness of the yield curve by taking the ratio of the yield of the 3-month T-Bill to the yield of the 10-year Treasury note. The lower the ratio, the more steep the curve and the higher the ratio the more flat the curve. The following table breaks down the cycles prior to March 1982.
Yield Data During Flattening Cycles in the Inflation Era| 10-Yr. Yield | 3-Mo. Yield | % Change | ||||||
| Dates | Beg. Ratio | End. Ratio | Beg. | End | Beg. | End | 10-Yr. | 3-Month |
| 2/2/62 - 10/18/66 | 65.4% | 108.4% | 4.08% | 4.99% | 2.67% | 5.41% | 22% | 103% |
| 6/23/67 - 7/23/69 | 64.8% | 106.7% | 5.14% | 6.68% | 3.33% | 7.13% | 30% | 114% |
| 3/1/71 - 7/16/71 | 54.9% | 82.6% | 6.12% | 6.66% | 3.36% | 5.50% | 9% | 64% |
| 2/11/72 - 11/13/73 | 48.9% | 127.5% | 6.12% | 6.76% | 2.99% | 8.62% | 10% | 188% |
| 7/11/74 - 8/23/74 | 93.4% | 119.5% | 7.84% | 8.15% | 7.32% | 9.74% | 4% | 33% |
| 9/30/74 - 10/28/74 | 77.1% | 103.3% | 7.94% | 7.88% | 6.12% | 8.14% | -1% | 33% |
| 5/14/75 - 9/30/75 | 61.6% | 77.6% | 8.02% | 8.48% | 4.94% | 6.58% | 6% | 33% |
| 1/29/76 - 6/2/76 | 59.8% | 70.2% | 7.82% | 7.94% | 4.68% | 5.57% | 2% | 19% |
| 4/28/77 - 4/16/80 | 59.3% | 123.9% | 7.40% | 10.90% | 4.39% | 13.50% | 47% | 208% |
| 6/11/80 - 12/10/80 | 64.9% | 128.4% | 9.70% | 13.15% | 6.30% | 16.88% | 36% | 168% |
| 12/4/1981 - 2/16/82 | 75.6% | 100.3% | 13.15% | 14.53% | 9.94% | 14.57% | 10% | 47% |
As the table above shows, ten of the eleven cycles had long rates end higher than where they began. The average percentage change in the 10-year yield was 16% during this period while the 3-month yield increased by 92% on average.
Now let's turn to the data during the "disinflation era".
Yield Data During Flattening Cycles in the Disinflation Era| 10-Yr. Yield | 3-Mo. Yield | % Change | ||||||
| Dates | Beg. Ratio | End. Ratio | Beg. | End | Beg. | End | 10-Yr. | 3-Month |
| 8/26/82 - 9/19/84 | 56.9% | 83.8% | 12.55% | 12.25% | 7.14% | 10.27% | -2% | 44% |
| 6/26/85 - 4/2/86 | 66.3% | 86.5% | 10.54% | 7.33% | 6.99% | 6.34% | -30% | -9% |
| 9/12/86 - 2/11/87 | 67.8% | 79.5% | 7.63% | 7.37% | 5.17% | 5.86% | -3% | 13% |
| 10/29/87 - 6/9/89 | 56.6% | 100.9% | 8.89% | 8.15% | 5.03% | 8.22% | -8% | 63% |
| 10/26/92 - 12/4/95 | 42.8% | 94.3% | 6.83% | 5.63% | 2.92% | 5.31% | -18% | 82% |
| 5/3/96 - 9/11/98 | 72.5% | 97.9% | 6.90% | 4.85% | 5.00% | 4.75% | -30% | -5% |
| 10/16/98 - 12/10/98 | 80.2% | 96.5% | 4.44% | 4.53% | 3.56% | 4.37% | 2% | 23% |
| 6/7/99 - 1/2/01 | 75.7% | 115.7% | 5.81% | 4.92% | 4.40% | 5.69% | -15% | 29% |
| 1/8/04 - 4/4/05 | 20.1% | 62.6% | 4.27% | 4.47% | 0.86% | 2.80% | 5% | 226% |
It is too early to label the end of this tightening cycle but I put in yield data as of April 4, 2005 to create a frame of reference. One thing that jumps off the table is the fact that the most recent easing cycle led to the steepest yield curve on record. Not surprisingly, on a percentage basis the change in 3-month T-Bill yields is the largest increase over the 43 years covered by the data as the Fed aggressively tries to get back to a more neutral short-term interest rate from the emergency rates put forth in June 2003 to fight the deflation scare as well as put an end to the carry trade.
It is clear from the table above that the opposite dynamics have been in force during the disinflation era as compared to the inflationary era. Long rates have dropped seven out of eight times not including the most recent cycle since this one has not yet come to an end. In addition, the average percentage change in 10-year yields has been a negative 11% while the 3-month T-Bill has increased by 30% on average, far less than the 92% experienced during the inflationary era.
If history is any guide, then your outlook for long-term interest rates should be a function of your views regarding inflation. When inflation expectations were rising, both long-term and short-term interest rates rose during flattening cycles. When they were falling, then long-term interest rates dropped and short-term interest rates rose, albeit at a far less rate then the inflationary era.
So where do I stand? While I know there are a number of people who dogmatically believe that inflation is understated, I'm taking my cue from the bond market. Long-term interest rates have remained ranged-bound even in the face of rising inflationary expectations. The increase in inflationary expectations appear to be most anchored over the short-term (five years) as the break-even inflation rate for five-year TIPS (Treasury Inflation Protected Securities) has gone from 1.99% to 2.85% since January 8, 2004 (the date when the yield curve reached its steepest) while the 5-year Treasury yield has increased from 3.24% to 4.13%. 10-year break-even inflation has only increased from 2.28% to 2.68% while 10-year Treasury yields have only gone up 20 basis points from 4.27% to 4.47%.
I still believe that almost all of the flattening will continue to occur on the short-end of the curve. Until the recent Treasury rally, the pessimism among bond market investors and speculators was insanely negative providing for a great contrarian trading opportunity. I would still be long Treasuries. I believe our economy is far too finance-driven (read carry trade) and that this recent easing cycle has led to unprecedented debt accumulation by the household sector. Rapid interest rate increases will create significant headwinds for the economy and I believe Treasury investors know this. I also don't buy into the Asian central banks controlling our yields. Japan has reduced its Treasury holdings and it is no longer intervening to weaken its currency. Yes, China and other countries have picked up their buying, but I believe this is one market that is pretty efficient and that no single group of buyers can overly influence yields as the Treasury market traded over $600 billion per day in February according to the Federal Reserve Bank of New York.
Perhaps my relative calm regarding inflation and long-term yields is misplaced since the person who should be most familiar with interest rate history is Alan Greenspan himself. After all, he is largely responsible for the yield curve behavior during the disinflation era. The current cycle is playing out just like the script he wrote in the past. If he is questioning why the behavior of interest rates should be different when it so mirrors the recent past he helped create, then perhaps he believes that inflationary expectations are too modest and investors need to ratchet up their return requirements to compensate themselves for this risk. Maybe the real conundrum has nothing to do with Alan Greenspan, but myself. Perhaps the true conundrum may be that I am questioning why he thinks it's a conundrum. Now that's a real conundrum!
