The Road to Inversion

Chart of the Week for February 4-10, 2000

The credit markets are experiencing a rare phenomenon. Longer-term bonds have lower interest rates than shorter-term bonds. This is known as an inverted yield curve and has not been seen since December 1994. It is unusual for short-term yields to be higher than long-term yields as investors typically demand higher returns on longer maturities to compensate for the additional risk of lending money for a longer period. The two-year Treasury, as of last Friday, was yielding 0.36% higher than the 30-year Treasury.

Traditional thinking on an inverted yield curve would say that a recession could be likely within the next nine to twelve months. However, the circumstances causing this inversion have been as unusual as the inversion itself, leaving past indications virtually meaningless.

As the budget surplus continues to grow, the United States government has announced that it will buy existing Treasuries to reduce the national debt. Investors and traders are speculating that the majority of the purchases by the government will be existing 30-year Treasuries. Therefore, they are purchasing the bonds to benefit from the future buyback.

In addition to this buyback, the Treasury Department has announced that Treasury sales of all maturities will be reduced. The 30-year Treasury auction will only be offered once during the upcoming year. The anticipation of future supply concerns has also sent many investors scrambing to buy bonds. Even last week when the Federal Reserve announced they were raising short-term interest rates, the 30-year Treasury yield declined as investors tried to accumulate these securities. It is these unusual tactics by the US government which have led to the current inversion and confusion within the markets.

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