- by New Deal democrat
Something not just unusual, but unprecedented has happened in the bond market this year.
Normally, when an inverted yield curve (where earlier maturing bonds yield more than later maturing ones) regularizes, or un-inverts (where yields get higher the later the maturing), it is because the Fed has lowered rates sufficiently that all maturities, from 3 months to 30 years, follow them downward, but the shorter maturities decline in yield more.
An excellent example of this is the Fed easing on the cusp of the Great Recession. In January 2007, the yield curve was almost totally inverted (dark line). Maturities out through 10 years were not just lower than the Fed funds rate, but each longer maturing bond earned less than shorter maturing ones. The only exception was the thinly traded 20 year maturing. Even the 30 year bond yielded less than the Fed funds rate. As the Fed smelled increasing trouble, it made a series of rate cuts, and by March 2008 (the lighter shaded line) the curve had completely normalized, with shorter dated maturities declining in yield far more than longer dated ones:
But that’s not what has happened this year. The dark line in the below graph is the yield curve from December, while the lighter line is from the end of last week:
In December the yield curve was still inverted out through the 2 year maturity. By last week the yield curve had normalized, but not because earlier maturing bonds had declined in yeild, but rather because short to medium term yields had *increased* in yield, with yields from 3 months to 2 years progressively rising more.
I’ll spare you all the graphs I generated to test whether this year’s configuration was truly unique, but below are three of them. In all three, shorter maturing yeilds are lighter in color than longer maturing yields. (Note: these are not *all* maturities, but are representative. But be assured that I looked at every single maturity from 1 month to 30 years available on FRED, as far back as each series went).
First, here is the period of disinflation that started in 1982 and continued until the pandemic:
Each time following an inversion, the shortest dated yields fell the most, followed by more intermediate term yields, while the longer maturing yields declined only gradually.
But what about the inflationary 1960s and 1970s? Here is the first part of that era:
And here is the second part:
Again, in each case of an inverted yield curve (where the lighter colored matirties were higher in yield than the darker ones), *all* of the maturities declined in yield as the curve normalized, even though as time went on even the earliest maturities yielded more than they had before.
The closest analog to the present situtation I could find was the end of 1981, when the curve normalized as most yields stayed roughly the same as the (temporary) bottom in yields was imminent:
So the present situation in the bond market is one of a kind.
This unique event has probably happened because bond traders no longer expect further rate cuts, or at best they expect only one of them. Rather, traders likely expect at least some inflationary impulse over the next several years that mean that short term maturities must offer more yield to be competitive. Normally this has happened in an environment of an overheated economy which is gathering inflationary steam; as opposed to the current situation where for the past year about the only sector of the economy experiencing anything more than tepid growth has been related to the building of AI data centers.
This time around the inflationary expectations appear to all to be downstream of decisions in Washington which have been likely to shift both the supply and demand curves towards more inflation, including tariffs and the War with Iran resulting in the closure of the Strait of Hormuz (supply shocks) as well as a Federal budget that is most comparable to a Mafia bust-out (demand shock).
We live in interesting times.
