Of Pigeons, Information & Interest Rates
Have you ever noticed how pigeons walks? Their heads bob back and forth with each step they take. Although I consider myself a recreational bird watcher (as opposed to an actual birder), I never gave this behavior any thought until I read a fascinating book: Storm in a Teacup: The Physics of Everyday Life, by physicist Helen Czerski. The author explains that this movement is necessary because the bird cannot process the changing visual scene fast enough as it walks. Czerski writes: “The head stays in the same position throughout the step, so the pigeon has more time to analyze this scene before moving on to the next one.”
I can sympathize with the pigeon, since I often feel like there is way too much information available to me every day from numerous sources, all clamoring for my attention. After all, we live in the information age. And yet we must attempt to sort it out; to make some kind of sense out of it all; to discern the signal from the noise.
One of the five guiding principles of our investment philosophy at Coyle Financial Counsel is that investment decisions should be based on information, not emotions. And because we also seek to be evidence-based in our investment process, gathering and analyzing information is essential.
This will be the second Commentary in a row to discuss interest rates, but this time I want to address a point made in the video, that the yield curve is flattening. A yield curve (also known as the term structure of interest rates) plots the yield-to-maturity of an issuer’s debt securities by date of maturity. We want to answer the question of whether there is useful information in the shape of that curve.
Here is a plot of the term structure of U.S. Treasury debt for two different dates:
The curve dated January 2, 2014 is much steeper than the curve we have now. We know from last quarter’s Market Observer Commentary that inflation expectations are a key determinant of the general level of interest rates and that the Federal Reserve influences what short term interest rates will be through the market activities of the Federal Open Market Committee. Inflation expectations at the end of 2013 were higher than they are today.
Besides inflation, there is one other interesting historical feature of the shape of the yield curve which might give us information as to the future health of the economy. The measure we use for this is called the term spread, the yield difference between longer and shorter maturities. If we compare the current yield-to-maturity on the 10-Year maturity Treasury note (currently at 2.37%) to the 2-Year maturity (1.76%), the current term spread is 0.61%. This is the lowest reading we’ve seen in almost 10 years, since just before the Global Financial Crisis:
If you look closely at this chart, notice what happens to the term spread just before the economy slips into an economic recession (the gray vertical bars): the spread turns negative. This is called an inverted yield curve and it has been an almost infallible leading indicator of economic recessions in the U.S.
The intuition around using inverted yield curves as a recession indicator is as follows: an economy in significant decline tends to exhibit falling inflation, causing long term rates to fall along with falling inflation expectations. Short term rates, on the other hand, lag behind, anchored as they are by the Fed until it decides to start lowering them to stimulate the economy as it implements monetary policy.
Another theory used to explain this is called the Expectations Theory. The intuition here is that longer rates can be thought of as a series of future short term rates strung together. If investors believe that the Fed will start lowering short term rates in the future, they will start buying more long term securities to lock in higher yields, which gradually has the effect of lowering long term rates (this is because bond prices and yield are mathematically inversely related).
A declining (but still positive) term spread is certainly not cause for alarm. A quick glance at the graph shows many instances since 1976 where it declined but failed to invert. It is just one of many economic variables that we monitor as part of our investment process. While recessions are notoriously hard to predict, we don’t believe the U.S. is in any immediate danger of slipping into one.
As we mentioned last quarter, we are not in the business of predicting the future course of interest rates. But, like the pigeon, we try our best to process the continuous flow of economic and market information available to us, without getting too overloaded. Even so, trying to discern the signal from all the noise is easier said than done.