Growth Cycles, Interest Rates and the Yield Curve

Watching the news this week we saw the recent ramp up in bond yields pull back with terrible US housing data.  Although the news was somewhat overshadowed by the breakdown at the NASDAQ ( - more on that some other time), it did cause stocks to resume their climb after a few days of heavy selling. Most economists think of this as "overshooting" - in other words, interest rates may have gone up too much too fast, which has caused a stall in the housing pickup leading to the Fed stating that it would be flexible if the economic sputters rather than slowly accelerates, which in turn leads bond yields to fall again.

US real GDP growth - quarterly at an annual rate
Source: BEA

But in my opinion for whatever reason what we are seeing here is the growth cycle at work. Growth does not occur in a straight line as most economists assume in their models - growth appears to occur in small cycles, and this is pretty clear from the graph of real GDP shown above.  So you might ask why we are seeing a slow down in the housing market and other data, and yet the 2nd quarter growth rate was revised upwards.  Well part of the reason is that the real GDP release is a "rear view" measure - as it only captures growth up until the end of June, and the spike in interest rates largely occurred in July.  So likely we are in for a lower real GDP growth figure for the 3rd quarter as interest rates increased in the 3rd quarter.

Some commentators are now saying that this might give the Fed pause in terms of starting it's "tapering" program to scale back purchases or bonds and other financial instruments.  I really don't think so as US growth is still positive and at a 2.5% rate, hardly sluggish now.  And remember that the "taper" only slows down the purchases, leaving the Fed the room to vary the rate of decline in these purchases if it wishes.

So "tapering" is really going to be happening sooner rather than later in my view.  But we know that expectations usually act ahead of policy actions, and indeed some of the run up in bond yields has already occurred, but I thought it would be good to review exactly what might happen to the yield curve over the next year or so given where we currently are in the business cycle.  The yield curve is a plot of the bond yields of different maturity government bonds at any given point in time.  So the exercise here is to try and deduce where bond yields should be at this stage of the business cycle without the monetary stimulus that the Fed has injected into the monetary side of the economy.

The big problem is what to compare the current level of bond yields to, so I decided to take two dates, so as to make an informed judgement about how far current yields are below where they should be at this stage of the business cycle. Given that we are now about 4-5 years since the end of the recession in June 2009, we are now 4 years from the end of the recession. Given this, I thought it would be good to compare the yield curves for roughly 4 years after the previous 2 recessions to where we are now.  Here are the results.

Yield curve comparisons

This comparison in one sense is not the best comparison as the peak of the business cycle after the 2001 recession occurred in 2006, and this can be seen as the flattened yield curve in 2006, but it does give us an idea about where interest rates should be under normal circumstances.  As can be seen, 5% appears to be roughly where bond yields should be - but current bond yields are far below this level, with only the really long term bonds now approaching roughly 1% below the 5% level.  This is due to "operation twist" ending, and the surge in long term bond yields that has occurred this year.

Here, we compare current yields to where the yield curve was about 5 years after the 1991-2 recession, and in 1997 the yield curve did have it's typical positive slope, as a recession was still a few years off in 2001, but in this instance yields were between 5 and 7%, way higher than where they are now.  Nevertheless we have the same general result - that short term rates are way lower than where they usually were at this stage of the business cycle.

The two charts really beg another question though - how will the yield curve move through time?  Obviously the "taper" implies that bonds will still be bought by the Fed, which will depress the short end of the curve for some time.  Some are betting that it's the 5 and 10 year bond yields that will move upwards most quickly now, but either way it is clear that the short end is where the biggest moves will occur once the Fed's exit strategy is fully realized.

Much will depend on economic developments over the next couple of years and how the new Fed Chairman decides to execute the Fed's exit strategy.

[Investment tips: If you want to ride the wave to higher bond yields at the shorter end of the yield curve, two ETF investment vehicles that would correspond to this movement are DTUS and TBZ, both inverse short term maturity bond ETFs ( - TBZ is a 2x leveraged ETF); if you are interested in the middle of the yield curve, TBX and TYNS are the inverse non-leveraged ETFs and TYO is the 3x leveraged equivalent]