Applying the Concept:  Is the Recession Coming?                                            

Throughout 2005 the yield curve slowly flattened. The figure below shows that as the 3 month T-Bill rate rose from 2.3% in January to 4.0% by year end, the 10-year Treasury bond rate went from 4.2% to 4.4%.  This means that the term spread, the difference between the long and short term Treasury interest rate, fell from 2 percentage points to less than one-half a percentage point.  Historical experience suggests that when the economy is healthy, the term spread should be in the neighborhood of 1.25 percentage points – substantially lower than it was at the beginning of 2006. And, as we can see from figure 7.11 on page 171, when the term spread falls it is signal that the economy could be doing poorly. At the start of 2006, economists started to ask whether a recession was on the way.

Researchers trying to understand the fall in the term spread during 2005 focused on two possible explanations.  (1) Since the late 1990s foreign governments had been accumulating long-term US Treasury securities.   Was their high demand for the 10-year Treasury bond keeping its price up so that its interest rates stayed low?  And (2), was it possible that the risk premium on long-term bonds had fallen substantially eliminating the normal upward slope of the yield curve?

The first explanation was worrisome, since a point would surely come when foreign governments would change their minds.  When they do, long-term US interest rates could rise substantially. That is the 10-year Treasury bond rate would go up about one percentage point.  Fortunately, close examination allows us to dismiss this hypothesis.  Here’s why.

While it is true that between 2000 and 2005 foreign governments were purchased more the $600 billion worth of Treasury securities, it appears that they stopped buying them sometime during 2005 just as the term spread was disappearing.  Furthermore, if the explanation for the flat Treasury yield is that foreign governments have a preference for US Treasury issues, then the risk spread should have widened. That is, the difference between higher-default-risk corporate bonds and virtually riskless Treasurys should have grown.  It didn’t.  Throughout 2005 the spread between Baa rated corporate and 10-year Treasury bonds remained right around 1.8% for the entire year.

This brings us to the second explanation: that the risk premium fell.  Recall from page 165 that long-term interest rates are the average of expected future short term interest rates plus a risk premium (that’s rp_n in equation 8). The risk premium, which includes compensation for inflation risk, rises as the time to maturity of the bond increases.  So rp is higher for a 10 year bond than it is for a 1 year bond.  This is increasing risk premium is what gives the yield curve its upward slope.  But if inflation risk falls, then the risk premium will fall and the slope of the yield curve will fall with it. Remember risk comes from volatility, and the less volatile inflation is, the less inflation risk investors face.  The less risk there is, the less compensation there will be.  As a consequence of successful Federal Reserve policy (you will read about this starting in Chapter 15), US inflation in now both lower and more stable that it once was.  In fact, some people believe that inflation risk has disappeared.  With no inflation risk, there is no inflation risk premium, and the yield curve will be flatter.  It doesn’t look like there is much to worry about.