Monday, February 28, 2011

Thoughts on the Yield Curve



I've been thinking today about the shape of the yield curve for both nominal treasuries and ones with inflation protection. I would like to know why the shapes of the yield curves are generally so similar.

As seen in the following chart, the deflationary event caused the shapes to diverge wildly. The bond market was caught completely by surprise.



So let's go through the risks and try to figure out why the shapes would be the same.

Investopedia: 6 Biggest Bond Risks

1. Interest Rate Risk

The US debt could fall out of favor. We saw this during the dotcom bubble. Interest rates were much higher because investors felt more money could be made elsewhere.

2. Reinvestment Risk

None of this debt is callable. This risk therefore does not apply to treasuries.

3. Inflation Risk

This is not a trivial risk, as last seen during the 1970s.

4. Credit/Default Risk

There's a risk the government simply does not pay its debts. I don't think this risk is trivial, but inflation would seem to be the more likely mechanism. The government has promised to pay paper dollars to its creditors. It can meet that obligation. It has not promised what the paper dollars will be worth though.

5. Rating Downgrades

This is already covered in the credit/default risk.

6. Liquidity Risk

There is some extra liquidity risk in TIPS perhaps, but unless you are trying to move hundreds of billions of dollars or more in bonds within a single day the markets are fairly liquid.

I'm going to offer my own version of these risks.

A. Default Risk

There are two ways the US could default.

A1. Inflation could rise significantly. I would argue that nearly none of this risk is being priced in. If it was then the yield curves would not match so closely. If inflation was the reason investors need a higher yield in order to justify owning long-term treasuries, then why do they also require that same higher yield for treasuries that have inflation protection?

Here is another way to make the same point. The bond market expects the CPI to increase by 2.6% per year on average over the next 20 years. You get this figure simply by subtracting the 20-year TIPS yield from the 20-year nominal treasury yield.

Here's the really amusing part. Guess what the average annual inflation rate has been over the last 20 years. Try
2.5%. No joke. The bond market is simply predicting more of the same. That's all it is doing. At best, it has priced in a measly 0.1% premium.

A2. The US could decide not to pay its debts. The long-term risk would be very similar for both treasuries without inflation protection and for those with inflation protection. This would explain the similarity in shapes between the two yield curves.

Now let's try to figure out if this makes sense. In my opinion, the most likely way for the US to default on its debt is through inflation. I just made the case that this risk is most likely not priced in. If the most obvious form of default isn't priced in then what are the odds that this other form of default is priced in?

If I am right to think that way then what risk is being priced in? Why do investors require higher yields for longer durations?

B. Opportunity Risk

If you lock your money up for 20 years then you are taking a risk that you could have done better elsewhere. This would explain the shapes of the two yield curves and why they might directly match each other. It would not matter if you locked your money away in nominal treasuries or TIPS. The end result would be the same. The shapes of the yield curves would be similar.

This would also explain why real yields have generally been falling over the last decade. Some investors have realized that the biggest opportunities have been in losing money, not making it. First came the disappointing dotcom bubble and it was followed up by yet another stock bubble and housing bubble. Now that the stock market has nearly doubled off of its lows, we may get another losing money opportunity. Who really knows? I would certainly not rule it out.

As a side note, I will point out that the deflation risk was clearly not priced in. As seen in my second chart, the bond market was completely blindsided by it. It therefore doesn't take a huge leap of faith to think that the bond market could be blindsided again (either by deflation or inflation). In my opinion, the bond market is no more omniscient than the stock market is. Both markets stare blindly into the rear view mirror. I would not rely on either to make accurate predictions.

Source Data:
FRB: Selected Interest Rates

13 comments:

getyourselfconnected said...

Great post. I could spend many posts on the myth of "opportunity risk". Solid, regular returns are how you keep your money growing, not buzzsawed in the latest scam or hot stock move. I actually like TIPS (you may not believe that) but I just have not moved there as yet. I am having some fun trading stocks in the trading account but I am at the core mostly cash and physical gold/silver.

Mark, you may want to check out both Credit Bubble Stocks and Kid Dynamite as they both hit the nickels angle!

Stagflationary Mark said...

I checked it out.

On the one hand, I was comfortable owning 90% junk silver coins. I never intended to melt them and I didn't expect the next person to melt them either. We'd just keep regifting it like fruit cake, lol.

On the other hand, I'm not sure what the long-term demand for bags of nickels would be. A nickel apparently weighs 5 grams. At 7.5 cents per nickel, that's about 7 dollars per pound. Shipping costs could put a serious dent in one's potential profits (at least for small individual investors investing in nickel directly).

Look at the production. I see billions of nickels. The big risk here would be being the bag holder. Literally.

In defense of nickel hoarding, at least it isn't 24k gold plated steel in a wooden presentation box. ;)

Mr Slippery said...

@getyourselfconnected,

That is an interesting idea about hoarding nickels. I need to think it through. I'm a big fan of hoarding, but I am trying to imagine how I could store enough nickels to make it worthwhile.

$100 of nickels would be 2,000 nickels! 50 rolls I think. Very heavy, very bulky. It doesn't seem very practical.

Maybe you can start a physical nickel ETF?

@mark,

I think the parallel yield curve is underpricing inflation risk.

Stagflationary Mark said...

Oops. I said gold plated steel. It is actually a gold plated copper/nickel mix.

Quarter (United States coin)

Stagflationary Mark said...

Mr Slippery,

I think the parallel yield curve is underpricing inflation risk.

We'll know for sure in 20 years!

At best I suspect we'd see Japan's 0% inflation and at worst, well, things could get ugly in theory.

Of course, we might be able to recreate Japan's lost decades and tack on 2.6% inflation as well. In theory, the bond market could be right.

We certainly aren't Japan. They do not have the enormous trade deficit we do, although they are now making an attempt to start one.

Japan logs first trade deficit in 22 months in Jan

Feb 23 (Reuters) - Japan logged its first trade deficit in 22 months in January as exports to China and other parts of Asia slowed significantly, Ministry of Finance data showed on Wednesday.

Stagflationary Mark said...

Mr Slippery,

"That is an interesting idea about hoarding nickels. I need to think it through. I'm a big fan of hoarding, but I am trying to imagine how I could store enough nickels to make it worthwhile."

Find some like-minded investors and buy a warehouse? $7 per pound wouldn't be THAT bad if you thought you could find some end demand for the stuff at some point.

You'd need to add some labor costs to fill the warehouse though and some more labor to guard it.

Just a thought. You might find out that it just becomes a modestly profitable business venture though, even if things do work out well. It is work anyway. Lots of it. In the end, you might not be satisfied with the net salary.

My mom saw coin arbitrage first hand at her bank in Eastern Washington many years ago. The bank decided it would be easier just to take Canadian coins at face value. That policy didn't last long. People would drive to Canada to buy coins in bulk and then exchange them at the bank for US dollars.

Stagflationary Mark said...

Here's a bonus idea. Team up with Coinstar? They might be willing to transport those nickels to your warehouse if you paid them 5.5 cents each for them?

getyourselfconnected said...

OMFG, some folks are going long nickels tommorrow I fear!

Stagflationary Mark said...

GYSC,

The following is why I really enjoy having this blog. I was just about to make a joke based on your comment but it is now much funnier!

NickelStar.com is for sale

Click here to buy NickelStar.com for $1,995

OMG!

I'm picturing webcams in your warehouse so investors could admire their bulky nickels from anywhere on the planet!

You know the crazy thing? It might actually work as a business model these days, lol.

Stagflationary Mark said...

I see that NickelEnergy.com will cost you $5,390, lol.

It's got everything you need though.

1. Base metals
2. Energy
3. Dotcom

Stagflationary Mark said...

Margin.com is for sale

Click here to buy Margin.com for $3,500,000

Holy crap. It is the second most expensive domain for sale on their site. If that isn't a sign of the times then I don't know what is.

Stagflationary Mark said...

Okay, that's weird.

Margin.com

Margin.com is becoming a rapidly growing resource and authority, while striving to maintain high standards of quality. We look forward to being an excellent resource for you for years to come.

Emphasis added.

Or until we cash out for $3.5 million?

The Internet is wonderful. I just want to point that out, lol.

AllanF said...

I remember reading the post where he put the question out about a deflationary protected inflation hedge. I came up with pure copper pennies, which seemed about as practical a solution as Mark's forever stamps.

The nickel idea though I like. MoM readers may remember I've got a few hundred in cash from Chase upping the fee on checking accounts. Now I think I know what I'm going to do with the cash. And as I'm ostensibly still a customer (I didn't close the account, I withdrew everything but 5 cents), they'll have to give me all their quarters.