Here goes: I hear the heads on business news channels talking about the Fed Funds Rate and the 2 Year treasury a lot lately. Everyone seems to be concerned with the fact that the Fed Funds Rate is much higher than the yield on the 2 year treasury. Are people concerned with this b/c it presents a dip in the yield curve on the short end of the spectrum? Is there some other relationship beyond this that typically exists that I am missing? What are the repercussions of this if it continues? I know this is basic, but it’s something I haven’t got a handle on yet.
Well, if you believe in cycles (what goes up must come down), the usual explanation is this: inverted yield curve -> short rates are unusually high -> Fed tightened them to cool overheated economy -> the good times are about to end A lot of loose correlations in that line of reasoning; historically it’s been very hard to predict recessions, so worrying might not be too fruitful.
Bodymore, DarienHacker makes the point fine, but if you want to read about the theory, it is sort of covered in the CFA curriculum… There are 3 ways to explain the shape of the yield curve: i) pure expectations hypothesis, ii) liquidity premium and iii) the clientele effect. The first one of these is the relevant one. To the extent that the yield curve embodies future rate expectations, the fact that 2 year yields are so far below Fed Funds (Fed Funds is the overnight rate banks earn on deposits at the Fed) indicates that the market anticipates sharply lower rates. i.e. the yield curve is pricing in a certain probability (say 50%, off the top of my head) that a recession causes the Fed to cut aggressively. This is because investing overnight for 2 years (i.e. at Fed Funds for 2 years) should be exactly equivalent to investing in a 2 year treasury bond (according to the pure expectations hypothesis). Hope this clarifies things.
Bodymore Wrote: ------------------------------------------------------- > Here goes: > > I hear the heads on business news channels talking > about the Fed Funds Rate and the 2 Year treasury a > lot lately. Everyone seems to be concerned with > the fact that the Fed Funds Rate is much higher > than the yield on the 2 year treasury. > It implies that the market is anticipating both lower rates (due to recession??) and also that there is a flight to quality and liquidity. Both of which are never good for the markets or the economy.
Thanks for the responses. One more question: Under these circumstances, does the Fed lower rates specifically to “get rid of the dip” in the yield curve? In other words, is the market telling the Fed where rates should be at this point?
Bodymore Wrote: ------------------------------------------------------- > Thanks for the responses. > > One more question: Under these circumstances, > does the Fed lower rates specifically to “get rid > of the dip” in the yield curve? In other words, > is the market telling the Fed where rates should > be at this point? no.
IMHO, the fed would lower rates to get rid of the inverted yield curve if it could (i.e. inflation wasn’t a problem, excess capacity, etc… that isn’t the case now).
Sounds good. Thanks for the input - it helps me piece together what I am learning with the “real world”