Client Affairs

The Mystery of the Flat Curve

Clark Winter, Citigroup Private Bank, Chief Global Investment Strategist & Editorial Board Member WealthBriefing, 19 July 2005

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The early summer’s divertissement is the great rate debate, which some are dubbing Greenspan’s “irrational conundrum.” It stems from US Fede...

The early summer’s divertissement is the great rate debate, which some are dubbing Greenspan’s “irrational conundrum.” It stems from US Federal Reserve Chairman Alan Greenspan’s testimony before Congress’ Joint Economic Committee in February.

There he observed that the stubborn refusal of long-term bond yields to rise as the Fed raised short-term rates was a puzzle; he couldn’t make sense of it.

A lot of ink has been shed since that time, as short-term rates have moved higher and the yield on 10-year Treasurys has fallen, so that the yield curve is now virtually flat. Generally, when spot and future commodity prices of any kind converge — and interest rates are really just another commodity — there is some agreement in the marketplace that the present price will hold into the future.

The question is, why is that happening with interest rates now? Here are a few possible answers bouncing around Wall Street:

Relative attractiveness — With rates so low around the world, global investors, especially Asian central banks, think 10-year US notes, at 4 per cent, still offer a pretty good return for idle money. Just as in the early 1990s, the US has become the place to park cash until it is put to use elsewhere.

Scarce appetite for equities — While we remain bullish on US equities for the long term, others clearly are not so positive. Perhaps a retiring Baby Boom generation, having been burned by the stock market, sees few compelling reasons to move into equities, particularly when it is possible to get a risk-free return elsewhere that is better than the average dividend payout. Pension funds too may be trying to fulfill future obligations by buying longer tenor assets and shying away from stocks.

Low inflation expectations — The falling price of goods due to cheap Chinese labour, as well as the Fed’s telegraphing of its intentions, fuels estimates for low inflation. As far as China is concerned, there are even more inflation-stomping price cuts to come. As Chinese wages rise toward those in other emerging markets, China will aggressively cut costs all the way up the supply chain, chipping away internal transportation and logistical costs in order to maintain its current economic advantage.

Greenspan really likes low rates — Call this Chairman Greenspan’s dirty little secret, but one could speculate that he actually likes falling long rates because it means that the future interest burden on Americans will remain moderate, giving the current and future administrations some fiscal policy wiggle room.

Namely, cheap financing means that the US will probably not have to raise taxes to dig itself out of the $4 trillion fiscal hole it is in, which leaves plenty of extra money for Americans to spend on Asian-made goods, keeping the global economy chugging along. And while Greenspan has talked up rates, he has done so with little enthusiasm. Perhaps he is looking for a little benign neglect to keep interest rates low.

Or maybe, as some say, the flat curve is auguring a US recession brought on by profligate spending. All of this, of course, is just an articulation of the collective mind of the market. As we’ve seen time and again — as with the late 1990s tech bubble and the dollar recently — the market can change its mind very quickly. That’s why when anomalies occur, such as the yield curve falling and flattening in the face of steady sustained growth, it pays to question the market’s beliefs.

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