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