Fed FAQ - Why interest rates matter
We spend a lot time fretting over the stocks in our retirement accounts. The bond market, however, may be a better gauge of what the future holds for our jobs and our ability to save for retirement.
The bond market is large and can give clues to future economic conditions. A particularly useful framework for describing bond market conditions and expectations is the yield curve, also called the yield spread. This curve or spread reflects the relationship between interest rates on a particular debt security with different terms to maturity.
The yield curve for U.S. Treasury notes and bonds is now nearly flat. The difference between the two- and 10-year yields is only a fraction of a percentage point. Whether the shape of the yield curve is flat, upward sloping (indicating higher long-term rates) or downward sloping (lower long-term rates) depends on factors that can be classified into two general categories.
First, the shape of the curve is influenced by investors’ expectations of future interest rates.
If the curve is downward sloping or flat, as it is today, it is likely that investors believe that rates will be lower in the future. In this case, investors are buying more and more long-term securities on the secondary market to capture their high current rates, pushing their yields down (the yield on a bond and its price are inversely related — the higher the price, the less revenue the bond yields).
Conversely, if the yield curve is upward sloping, investors expect future rates to rise.
A second factor that can explain the spread or shape of the curve is that investors perceive the risks of holding securities for longer periods of time to be greater than those of holding for shorter periods. This preference for shorter-term securities is called the liquidity premium.
The liquidity premium is due to the fact that the longer the time until the principal is due to be returned, the higher the probability that the principal will not be returned. As the preference for short-term debt becomes greater, investors sell current long-term securities and buy short-term securities, respectively raising and lowering the yields on each.
Outside the U.S. the liquidity premium appears to be very strong. Yields on long-term government bonds in both Europe and Japan are negative. Investors in those markets are paying governments to hold their cash for them.
Today’s liquidity premium is high, suggesting the economic outlook is weak. Policymakers would be wise to listen to the bond market.
Peter Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. firstname.lastname@example.org