Publications

Yield Curve Takes on a New Shape

Dayton Business Journal - February 2006
Expert Advice Column by Kathleen A. Carlson

Much has been made of the inverted yield curve where the 4.75% yield on the 1-year treasury is above the 4.60% yield on the 10-year treasury. In past business cycles, it has preceded a significant slowdown in the rate of growth in the economy. Should we be seeking shelter from an economic storm?

Before I answer, I need to remind my readers that I grew up in a farming community in Arnold, Missouri. Folks there never go straight into the barn to feed the livestock. First, they have to circle the perimeter to be sure it's safe. Then, they get to the feeding chores. So, I digress for a moment ...

The trade deficit hit an all time high both in terms of dollars and as a percent of our economy in 2005. Last year, we imported $700 billion more of goods and service than we exported, equaling 6% of gross domestic product. If we keep up December's pace for all of 2006, the deficit would be close to $800 billion.

While oil imports priced above $60 per barrel certainly contributed to the record, our nearly insatiable appetite for low priced goods and services produced by a nearly inexhaustible supply of low priced, foreign labor also played a roll. Although not so good for our domestic manufacturers, our demand for imported goods and services, like flat screen TVs and outsourced help desks, fueled a worldwide expansion. Even Japan has started to see some real economic growth after a decade of stagnation.

The growing world economy has generated a glut of cash. And what do business owners do with excess cash? They reinvest it in their businesses, pay it out to their owners or invest it in something else. Some of that something else has been U.S. treasury bonds, for as low as our domestic interest rates are today, they are high by international standards. Interest rates in England are similar to ours. Their 1-year securities yield 4.3% and 10-year securities around 4.2%. Yields in the Euro market are even lower at 2.8% and 3.5% respectively. We can understand why the Japanese invest so much of their cash in our market. The yields on their 1-year securities of 0.1% and 10-year securities of 1.6% are hard to comprehend.

As a result, international holdings of our debt have skyrocketed. Foreigners hold more than two-third's of the U.S Treasury's total outstanding debt, maturing in 1 to 10 years. Last year, foreign purchases accounted for more than 80% of all new treasury issues. This explains a lot. It explains why our deficits haven't caused us the problems many economists fret about, and, why long-term interest rates haven't risen since the Fed Reserve started raising short rates over 18 months ago.

Our 1-year treasury is priced with an expectation that the Federal Reserve will raise rates for a 16th time. The yield on the 10-year treasury is a function of the supply of and demand for our bonds in the world marketplace. Going into the barn now, we believe the inverted curve is the result of market forces driven by the Fed on the short-end and the strong global demand for yield on the long-end. With the world awash with cash, flat and slightly inverted yield curves may become the norm.

Who would have thought our debt would be one of our strongest exports. Foreign demand for it has kept us from suffering from the consequences of our twin deficits. Let's hope demand stays so hot.