Clint Burdett Strategic Conslulting
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Interpreting Yield Spreads <Return to Risk>

This rambles, a work in progress:

The New York Federal Reserve calculates the Constant Maturity Treasury (CMT) rates at the end of the trading day. Constant maturity is an adjustment for equivalent maturity made by the Federal Reserve Board to compute an index based on the average yield of various Treasury securities maturing at different periods. These CMT yields are used to compare the spread on the yield curve, the difference in yields for Treasury A to Treasury B for sale.

My observations of economic behaviors suggested by CMT yield spreads I hope is more nuanced than a "flight to safety" used by the media and is derived from my consulting years planning strategic use of funds.

Examples:

I still have trouble getting my head around yield curve analyses, too simple a measure for very complicated politics, economics, and behavior. It is just a technique to assess Treasury paper buyers/sellers' perception of risk - a leading indicator for GDP shrinking.

Trying again to set the stage, traders simplest choices are:

If shorter term yields are rising in an “inverted yield curve”, which can signal an impending recession, as the Value Line team concludes, investors "often shun shorter-term paper out of fear business conditions will continue to deteriorate" and buy longer term paper as yields are falling relative to short term yields to protect cash for duration of the downturn.

Restated from the Risk Section, when the over-the-counter yields for CMTs converge, shorter term yields rise (prices fall) and long term yields decline (prices rise). There is more uncertainty about making long term commercial commitments, hence converging CMT yields converging are a proxy for increased market risk.

Buyers are willing to pay to preserve cash in a safe investment where they perceived business conditions will deteriorate.

Sellers have more reason in the open market to seek cash, such as: shifting cash to better investments, executing a plan, hedging against liquidity risk (you need more cash in the bank) or moving to Government paper early (worrying a "bubble will burst" - get out of X now and protect your cash). If you ever worry about US Government paper liquidity, stop reading this and hoard food.

The worst case: during that 2007-2008 financial crisis, the TED spread was the measure of credit risk to borrow cash, comparing very short term yields, the difference between the interest rate on short-term US government debt and the interest rate on interbank loans. In September 2008, the Ted Spread spiked and commercial credit was very, very expensive or not offered. In mania, you cannot get credit to borrow even short term, there are runs on financial institutions and the government becomes the lender of last resort. Briefly in September and October 2008, the mid- and long-term borrowing in commercial markets had essentially "shut down." CMT yields collapsed once the Fed as the lender of last resort, moved to restore favorable credit conditions and CMT spreads slowly returned to normal.

What behavior causes a buyer of CMTs in the open market to choose the shorter term paper over a longer term or vice versa?

  1. Investors are selling stocks, shifting their money to bonds to preserve cash, to avoid future stock losses, especially where an Administration could create a market loss for short seller advantage or to reduce personal interest costs (OMG - elite corruption - at 67, I have never said that).
  2. Speculation that rates will fall more and increase the price of the Federal paper OTC, i.e., the Fed lowers the discount rate, a sellers investment profit decision.
  3. Don't tie up cash long term, wait for the shorter term paper to mature at face value, a near term cash flow decision.
  4. Perceive cash in Federal paper long term until GDP growth accelerates again.
  5. Maneuver to benefit from an eventual decline. When 2 year CMT Notes pay more interest than 10 Year CMTs, the recession in 11-24 months off.
  6. and on and on.

My rant on the Great Recession, lessons learned:

The hard bit for me to grasp is that fixed income securities change hands many times before they mature so each buyer is computing a yield at the price for the remaining term for each purchase. The buyer, how much future cash do I buy now, why? Will these Treasuries or other fixed income securities be collateral for construction loans or safe havens until a better opportunity appears? The seller, how much cash to get out now and why? Do sellers need cash now for routine cash flow or to payoff the contract obligations or other debts? There are many sophisticated individual and institutional sellers and buyers with different motivations, and it can get out of hand in fierce competition, especially in the Financial Industry.

The Great Recession was triggered by a liquidity trap caused by the Financial Industry resale of mortgage backed securities — as the securities fell in value, Financial Institution with large portfolios of them became insolvent and quickly overnight or long term lenders stop lending. The stage was set described in this Wikipedia article and its underlying articles.

The buyer/seller risk calculations were made investors in so-called "government backed" home-related securities in the 2007-2010 subprime mortgage crisis, which were repackaged as "safe investments implicatively back by the US Government." Key market players believed the hype; it was herd behavior.

In 2007-2008, there was slow rolling mania risk. In the housing bubble a run-up in home prices fueled speculation, and exuberance in the mortgage resale markets where time-bound payouts to investors from mortgage backed securities were dependent on home owners making their payments and an implied backup from Freddie Mac or Fannie Mae. It burst when demand fell for new homes that had fueled mortgage growth, many home owners were under-water (negative equity), could not sell their home (to access to cash) or worse, could not make their mortgage payments and in turn, owners of mortgage backed securities, banks and investment firms, could not make payments to their investors. Mortgage backed securites plunged in value. Suddenly, “everyone” needed cash now to avoid default (or no cash flow from a worthless security) and CMT OTC yields rose (early warning) in 2006 and stayed converged in 2007 in the "flight to safety." The Great Recession lasted 18 months until June 2009.

Like many, I lost thousands by joining the herd late. Freddie Mac went into conservatorship (bankruptcy), voided its preferred stock.

The warning pattern for a flight to safety, CMT rates converging, was evident well before the credit crisis.

 

Articles:

The San Francisco Fed considers the 3m T Bill to 10 Year Note spread a slightly better leading indicator of a recession.

Chinn from Econbrowser discusses the 5yr - 3m spread (proxy for long-term assets purchases) as a leading indicator.

Hamilton from Econbrowser cautions reading too much into inverted yield curves, using a 3m-10 analysis.

 


Authored by Clint Burdett Strategic Consulting
A Practical Guide to Strategic Planning
©Arthur Clinton Burdett III- All Rights Reserved

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