Friday, December 22, 2017

The bond yield conundrum: 100 years of spreads

 - by New Deal democrat

As I mentioned the other day, we have data going back nearly 100 years on the relationships between short and long rates, and between corporate bonds and treasuries. I'm looking at this because the yield curve never inverted between 1932 and 1954, during which time there were 5 recessions, one of which (1938) was severe.

Last time I showed you the data since 1980 when the disinflationary trend started, so now let's look at the last deflationary period of the 1920s and 1930s, and the inflationary period from the end of World War 2 to 1980.

Let's start with the deflationary 1920s and 1930s:

The US Treasury bond trend looks very similar to the last decade. Over a 20 year period, yields fell gradually from 4% to 2%, with barely a blip during either of the two severe recessions during that period.  Meanwhile BAA corporate yields were much more volatile, but gave little warning of the 1938 recession, and none at all in 1926.

Here's what the spread between the two looked like, compared with the NY Fed's discount rate. Note that prior to 1934, the regional Feds set their own rates. After that, the NY Fed rate and the national rate were identical:

Discount rates were raised, ultimately sharply, in the late 1920s, but were completely flat prior to the deep 1938 recession. "Real" rates were positive only because the spread declined. Further, the spread between corporates and Treasuries gave only a few months' warning prior to both severe recessions.

Now let's look at each decade separately from the end of WW2 to 1980:

With the exception of the first half of the 1960s, there is a rising trend throughout this era, with sharper rises in the years just before recessions.

Now here are spreads and the Fed funds rate (overlaid with the NY Fed discount rate in the 1950s):

This is the classic postwar Fed, raising rates significantly as the economy exhibits inflation, and lowering them as the recession takes hold.  Meanwhile the spread between corporates and Treasuries gives us much more notice, making a bottom in roughly the mid-part of expansions or even earlier, with the sole exception of 1953.

Looking back over 100 years of data, we see that usually (with the  pointed exception of 1938) the Fed is raising rates, by a smaller amount in deflationary environments, and a larger amount during inflationary environments.  In fact, the information is more useful if we look at the "percent of a percent," e.g., an increase from 1% to 2% is a 100% increase:

Further, during deflationary environments, waiting for an increase in spreads gives us much less notice of an oncoming recession, and even then the increase is well within the range of noise.

Well, we certainly have the Fed raising rates now, and as a "percent of a percent" at the highest rates ever, but the spread is close to all time lows.

What we still want to take a look at is real, inflation-adjusted rates.  That's next.