Wright's Model

The Yield Curve and Monetary Policy

A flat or inverted yield curve is normally caused by the Fed tightening monetary policy, driving up short-term rates to slow the economy and contain inflation. Recently, however, short-term rates have been at historically low levels and the flat yield curve is due to historically low long-term yields -- caused by low term premiums and low inflation expectations among other factors. Wright holds that when a flat yield curve is caused by factors other than tight monetary policy, its predictive ability is significantly reduced.

Reading a Yield Curve

In a normal market, short-term securities yield lower returns than those with longer maturity -- investors require a premium to tie up their money for a longer period (a term premium). If we plot the yields on a graph, you will see that the yield curve slopes upwards, with longer maturities returning higher yields. However, there are times when the market inverts and short-term yields exceed long-term yields. The yield curve then slopes downwards and is referred to as a negative (or inverted) yield curve.

Signals

Negative yield curves have proved to be reliable predictors of future recessions. This predictive ability is enhanced when the fed funds rate is high, signaling tight monetary policy.

• A flat yield curve is a moderate bear signal for equity markets.
  Banks suffer from a margin squeeze, as they pay mostly short-term rates to depositors while charging long-term rates to borrowers, and are reluctant to extend new credit.
• A negative yield curve is a strong bear signal.
  Normally caused by the Federal Reserve raising short-term interest rates to slow the economy, investors may contribute by driving long-term yields down -- switching out of equities into more secure investments.
• A steep yield curve is generally bullish for stock investors.
  The Fed may drive down short-term interest rates to stimulate the economy and investors contribute by switching out of bonds into equities, causing long-term yields to rise.

Yield Differential (or Spread)

The yield differential plots the difference between ten-year Treasury notes and 13-week Treasury bills as an approximation of the yield curve:

• A yield differential above 2% is a positive sign, indicating a steep yield curve;
• A yield differential below 1% signifies a flattening yield curve;
• A yield differential below zero signals a negative (or inverted) yield curve.