Thursday, April 1, 2010

What's the Yield Curve Signaling?

Paul Krugman recently put up a post arguing against inflationary fears by stating that, because we're up against the zero-bound on short-term rates, the yield curve is not currently pricing in inflationary expectations. Since long term rates can't be negative, the yield curve has to be upward-sloping. Jake, over at Econompic followed up Krugman's post by running a simulation which further highlighted that yield curve steepness is also a result of being up against the lower bound.
I agree wholeheartedly with them that inflation fears aren't currently priced into the yield curve, but both of them missed the chance to point out other reasons for a steepening yield curve.
First of all, they both assume rates reflect future expectations. And, of course, they do to some degree, but not in totality.
Institutional investors purchase treasuries with specific yields to match maturities on expected redemptions, payouts etc.
Liquidity Preference Theory also plays a big role in the yield curve and I imagine there's a wide swath of investors out there who want a more liquid, short-term investment rather than hold the long bond. Why? Well, with signs (generally) pointing to some sort of recovery, investors don't want to get locked into long-term, low-yield treasuries if they feel a better return in emerging markets (for instance) is just around the corner.
I must admit that Pure Expectations Theory is the most widely-held view of why the yield curve is shaped the way it is and why it's steep or flat. But, in reality, there has to be accounting for the other two theories as well... and all three can be used to combat the inflation hawks.

No comments: