Why the Yield Curve Is Not the Bellwether It Used to Be

The entire government debt market is so manipulated by the Fed and major foreign governments that the yield curve no longer says much about market beliefs, according to Dr. Peter Linneman.

To our chagrin and despite the growing economy, the Fed surprised no one (but confused many) when it lowered its key interest rate by 25 bps in late July 2019. This is the first monetary easing by the Fed in more than a decade. Current U.S. fiscal and monetary policy is following Japan down the rat hole of no growth. Low rates facilitate wasteful government spending that stimulates nothing but pork barrel recipients and lobbyists. Artificially low interest rates also distort capital allocation. Large government borrowing crowds out more productive capital users, and free money to the government encourages reckless federal spending.

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It has worked no more effectively in the U.S. than in Japan or Europe. The only difference is that reduced regulatory burdens and lower taxes have enabled U.S. growth to continue in spite of low rates. Meanwhile, the Fed continues to pretend it can predict and direct the economy when the data shows they can predict neither the economy nor even their own policies. They need to do less, not more, in order to assist the economy. They are the disease not the cure. Remember that the 12 most dangerous words are “I am from the government and I am here to help you.”

The Shadow Knows

Dr. Peter Linneman
Dr. Peter Linneman

The shadow yield curve is a synthetic exercise that attempts to adjust the yield curve for the impact of quantitative easing. It is correct in direction but wrong in magnitude. The recent yield curve inversion is odd, as the real 10-year rate is about zero, while the real short rate is about 50 bps. In contrast, an inverted yield curve has historically occurred at positive real rates. It is hard to believe the “market” believes long-term inflation is 50 bps below the current rate and that the long-term real rate should be zero percent.

The truth is that the entire government debt market is so manipulated by the Fed and major foreign governments that the yield curve no longer says much about market beliefs. Rather, it speaks much more about expected government market manipulation. In this regard, it simply says that investors believe the Fed will be bullied into cutting short rates to undo the negative yield curve. This ripples into the long rate, which is simply the time-weighted average of expected future short rates. So, if investors expect the Fed to manipulate short rates downward again (which they did for almost a decade) and keep them there for some time due to fear of Wall Street wrath, the long rate falls below the short rate until the Fed caves. Alternatively, the Fed could display Volker-like courage and do what is right by raising short rates since, in the absence of notable economic weakness, there is no justification for Fed intervention. That is, the Fed should leave rates alone absent exigent circumstances. In the meantime, innocent bond holders are whipsawed by speculation on Fed manipulation. But understand that today’s rates do not reflect “market” rates in any meaningful sense. Instead, this bond market is now a bet on government manipulation.

Dr. Peter Linneman is a principal and founder of Linneman Associates and Professor Emeritus at the Wharton School of Business, University of Pennsylvania.

Read the November 2019 issue of CPE.