Yield Curve Thoughts

Click to enlarge.

The data is a pretty good fit so I've extrapolated the trends backwards in time 5 years to cover the full range of the chart.

I'd like to take a moment to discuss how the short-term can appear fairly wild without actually being all that wild.

Picture your friend asks you to loan him $10.01 and he pays you back $10 one hour later. He then asks if you want that penny too and you tell him it is close enough. So how much would you have left if you did this every hour for an entire year? Here's the math.

(($10.00 / $10.01)^(24 * 365.25)) * $10.00 = $0.0016

You'd have about 1/6th of a penny left of your original $10. Behold the power of negative compound interest.

As seen in the next chart, short-term duration T-Bills do not pay the negative interest rates that the long-term trends would imply.



In my opinion, this logarithmic model breaks down due to the 0% floor. I think Ben Bernanke would set interest rates negative to match the model if he could though. Another way to put this is that the performance of buried cash is doing much better than Ben Bernanke would prefer. Should we slide back into deflation that would be especially true. Just something to think about.

As a side note, this chart reminds me a bit of my experiences at the horse races. The favorite (cash?) generally did not lose you money. If the races were even remotely rigged, the longshots (long-term bonds?) paid well. The worst bets were therefore what was left. Over the long-term, too many people betting on near favorites caused these horses to pay less than they deserved. Perhaps we are seeing that same effect in the 2-3 year Treasuries. I think they might be too popular for their own good. Note how far below the logarithmic trend line they are.

Please do not consider this to be investment advice. I don't own any Treasuries that don't offer inflation protection. My *bet* is on both the favorite (at least some long-term inflation) and the longshot (long-term TIPS held to maturity) simultaneously.

Daily Treasury Yield Curve Rates

Negative Yields and Nominal Constant Maturity Treasury Series Rates (CMTs). Current financial market conditions, in conjunction with extraordinary low levels of interest rates, have resulted in negative yields for some Treasury securities trading in the secondary market. Negative yields for Treasury securities most often reflect highly technical factors in Treasury markets related to the cash and repurchase agreement markets, and are at times unrelated to the time value of money.

As such, Treasury will restrict the use of negative input yields for securities used in deriving interest rates for the Treasury nominal Constant Maturity Treasury series (CMTs). Any CMT input points with negative yields will be reset to zero percent prior to use as inputs in the CMT derivation. This decision is consistent with Treasury not accepting negative yields in Treasury nominal security auctions.

The U.S. Treasury does not have a similar disclaimer for TIPS. Although I have yet to see an initial auction with a negative interest rate, I have seen a reopening of an auction have one.

October 25, 2010
TREASURY AUCTION RESULTS (5-Year TIPS)

High Yield: -0.550%

Technically speaking, the actual bonds still pay a positive interest rate of 0.5% (above and beyond the inflation rate). Investors simply bid them up.

TREASURY MARKETABLE SECURITIES TENDER INSTRUCTIONS

Note About TIPS: Should the accepted auction yield be 0% or less, the security will not have regular semiannual interest payments. The yield will be adjusted for inflation throughout its lifetime, thus posting changes at maturity (or sale). In this case, where the accepted auction yield is 0% or less, the interest rate will automatically be set at 0% (never anything lower) for all buyers.

Based on those tender instructions and the Treasury's comments about negative yields on nominal bonds, I'd be somewhat surprised if the 5-year TIPS yield is below 0% during the next initial auction on April 21, 2011. I could be reading this wrong, but 0% does seem to be the floor during an initial auction. I suppose it is possible that the bonds can have a 0% floor in an initial auction but you still need to pay a premium to get that rate. It seems unlikely to me though.

All I really know for sure is that I-Bonds do have a 0% floor and you will never need to pay a premium to get that rate. I-Bonds are therefore clearly a better choice than negative yielding TIPS for those planning to hold at least 5 years.

I have no "interest" in owning bonds that are virtually guaranteed to pay negative real interest rates. I'd much rather sit out at the longer durations and hold until maturity than be stuck accepting horrible short-term returns on the hopes that they don't stay permanently horrible.

This clearly isn't an option for everyone though. If you need the liquidity, you need the liquidity. Picture the older retired saver living on fixed income who can't afford to take the interest rate risk of holding long-term TIPS. He/she is the very person our monetary policy is targeting. It is such a sham(e).

Update:


I'd be a buyer of Ice Age bonds. I don't even care if I get paid back at maturity. A real yield of 10% or more would make one heck of a long-term annuity. Just throwing the idea out there on the off chance Ben Bernanke truly does want Americans to save more.

The United States must increase its national saving rate. - Ben Bernanke, October 19, 2009

Source Data:
Daily Treasury Yield Curve Rates
Daily Treasury Real Yield Curve Rates