"A Dedicated Follower of Fashion"

There appears to be a fashion in the press of discussing what information we can get from bond market yield curves. Astonishingly, the US yield curve even got a mention on the main BBC television news the other night. I nearly dropped my mug of tea. But just as when haute couture reaches your local high street or shopping mall you know it's pretty much over as a fashion (who can honestly deny thinking that maybe it was time to move on after seeing Versace yellow and black shirts on the beaches of Europe). The sound of newscasters telling you that there's a global recession coming because the US yield curve is inverted makes you think that maybe something is terribly wrong.

Yield curve theories come in a number of different styles 1 but economists will tell you that if long-term interest rates are lower than short-term interest rates then a recession is coming - for definite. In fact, some people these days even try and interpret the shape of the yield curve, which is just a simple plot of yields against years to maturity of available bonds, as an earthly revelation of what the future holds for a nation, or even the world, in terms of interest rates. Take the example below for instance, interest rates are, according to the first yield curve (labelled "inverted") going to trundle along at 5% for the next couple of years then there will be a deep and coruscating recession followed by a recovery.

As at 9 th June 2006.

Now look at the second yield curve (labelled "flat"). This is a transitional state, say economists, between expansion (a positive yield curve) and recession (an inverted yield curve). You have to admit it's a rather pleasing and convenient way of looking at the world as the future (or rather the expected future at any point in time) is laid out before us in all its simple glory. But more astute readers will know where I am going with this one; there is a trick here. Take a look at the scales on the graph. One goes from 4.9% to 5.1% (the "inverted" curve) while the other one goes from 0% to 6% (the "flat" curve). In fact in both cases it's exactly the same numbers taken from the US yield curve on 9th June 2006. All that happened was the presentation of them changed.

The fact is that yield curves have no predictive powers whatsoever. If they did then the UK, which has habitually had an inverted yield curve because of the distorting effects of the life and pension fund industry scooping up every long-dated bond the UK government cares to issue (and more), would have been in recession for the best part of a decade. Equally, we should be careful not to over interpret the meaning of the US yield curve at this time, especially when there are such fractional yield differences along it; there is a big difference between causality and coincidence. For sure, there are problems in the US which we are all expecting to come home to roost in the next couple of years but it won't be because the yield curve "predicted" it - right now that's just wishful thinking and even if a recession happened in short order it would be more a case of a coincidence than anything else.

The US Federal Reserve will, more than likely, increase interest rates in June again, the economy may moderate going forward but just like the UK, the logic doesn't automatically follow that a calamitous recession will ensue. Again, just like here in the UK, the US will probably end up with a situation that sees short-term interest rates in a relatively stable range, while bond yields vibrate within well-defined but restrictive boundaries. Equity markets will have their say in this process and the current bout of weakness at least puts a bid under the bond market that says to investors that the recent bond yield rises aren't the beginning of a secular bear market for bonds. Because timing is such an important part of this scenario we are using options to express a large part of our duration strategy in the US at this time. Meanwhile, the rest of the world will throw a party that we aren't invited to and all the time they will be wearing slightly more fashionable clothes than we can afford.