Thank you for writing this letter, from a Haas alumni! From what you have described, this may be another reason we will have an inverted yield curve for longer, but that does not necessarily mean a recession is imminent!
Marianne - thanks for reading. That's possible for sure. It's very hard to know because the Fed's involvement - or even just the potential for the Fed to be involved - in the bond market, makes it very hard to say what yields "should be". I think of the long yield as the short yield + bond risk premium. The BRP should consist of:
1. Inflation risk premium
2. Safe-haven discount - if bonds hedge a crisis this would push yields lower (because bonds are valuable), if bonds do not hedge a crisis then yields should be higher.
3. Supply/demand factors
4. Business cycle component.
I believe (1) should be positive and (2) is a wash right now - bonds ought to hedge a deflationary crisis if we have another one but won't hedge an inflationary crisis, like 2022.
(3) is obviously positive given the ugly deficit path.
(4) tricky - I would have thought we were in for a recession but economy still strong it seems.
So...putting all that together it feels like the yield curve "should" be positively sloped. But I agree that the Fed's potential involvement changes all this. Certainly if they buy bonds or are expected to cut rates, or both, that will cap long yields. And that seems to be where we are now.
Thank you Kevin for your detailed analysis and explanation. The term premium is quite difficult to estimate and therefore where long-term yield should be, but it is certainly heading higher, whether it will ever get to the 3, 4, 5% levels again, I don't think so, but that would scare a lot of new market participants who have been used to term premium less than 1%!
CC bringing the heat per usual ... it only took you 3 years to update the graph ... “thanks, Dad.”
It took time to decide on the color scheme
Thank you for writing this letter, from a Haas alumni! From what you have described, this may be another reason we will have an inverted yield curve for longer, but that does not necessarily mean a recession is imminent!
Marianne - thanks for reading. That's possible for sure. It's very hard to know because the Fed's involvement - or even just the potential for the Fed to be involved - in the bond market, makes it very hard to say what yields "should be". I think of the long yield as the short yield + bond risk premium. The BRP should consist of:
1. Inflation risk premium
2. Safe-haven discount - if bonds hedge a crisis this would push yields lower (because bonds are valuable), if bonds do not hedge a crisis then yields should be higher.
3. Supply/demand factors
4. Business cycle component.
I believe (1) should be positive and (2) is a wash right now - bonds ought to hedge a deflationary crisis if we have another one but won't hedge an inflationary crisis, like 2022.
(3) is obviously positive given the ugly deficit path.
(4) tricky - I would have thought we were in for a recession but economy still strong it seems.
So...putting all that together it feels like the yield curve "should" be positively sloped. But I agree that the Fed's potential involvement changes all this. Certainly if they buy bonds or are expected to cut rates, or both, that will cap long yields. And that seems to be where we are now.
Thank you Kevin for your detailed analysis and explanation. The term premium is quite difficult to estimate and therefore where long-term yield should be, but it is certainly heading higher, whether it will ever get to the 3, 4, 5% levels again, I don't think so, but that would scare a lot of new market participants who have been used to term premium less than 1%!