7 ms·

I am surprised this is not happening more frequently. An inversion between the 1 and 5 year bonds just means that the expected average yield for each of the nex

I am surprised this is not happening more frequently. An inversion between the 1 and 5 year bonds just means that the expected average yield for each of the next 5 years is less than the yield for next year. Statistically that should be the case 50% of the time. Treasure bonds are liquid, so buying a 5 year one does not mean that you have to hold it to maturity. Somebody tell me where I'm wrong.

pishpash 8y ago
Where are you getting this 50% from? Also, you're ignoring that there is more price risk in long bonds even if you can sell them, so there should anyway be a term premium (upward-sloping curve) even if the expected interest rate over five years is constant.
sf_rob 8y ago
>Statistically that should be the case 50% of the time. Only if the risk premium is the same. >Treasure bonds are liquid, so buying a 5 year one does not mean that you have to hold it to maturity. Here you claim that the risk premium is the same because it's liquid. However the term is not the same so you'll be hit with a bigger effect when short term interest rates change on a longer time horizon instrument.
nickles 8y ago
There are a few factors that cause one to expect a monotonically increasing, concave yield curve [0]. Firstly, one must consider the term premium [1]. In short, you expect to be compensated more for lending money for a longer period of time. Consider lending money for two years. You could lend your money in two single year-long increments, in which case you would compound your gains from the first year when you lend out the second year. If you lend in a single, two year-long commitment, you rationally expect, all else being equal, to earn as much as you would have by lending as described previously. This drives the general upwards slope (or contango) of the yield curve. Next, consider a credit component. When you lend someone money, how likely is it that you are paid back? If you expect there is default risk, you factor that into the interest rate you demand. As the tenor of the bond increases, the risk of default increases. However, the extra interest you demand for credit risk also decreases as time goes out. Why? What are the chances that someone defaults on a loan between 5 and 10 years? Probably greater than the risk that the party defaults between 10 and 15 years. This drives the concavity of the yield curve. Finally, the movement in the curve is driven by expectations of future interest rates, as determined by Federal Reserve policy. Fed typically acts at the short end of the curve. In its tool chest, fed can manipulate rates like the fed funds rate, IOER, and ON REPO. As the economy improves, fed will raise rates. When economic outlook declines, fed will lower rates. If you expect that rates will be higher in the future, you will demand higher yields for longer dated bonds, since your invested money will earn less of a premium to interest rates in the future relative to where you invested today. On the flip side, if you expect interest rates to decline, you will want to lock in your money now, so you purchase longer dated bonds, since you do not expect to be able to get as high a yield in the future. This action at the long end of the curve, coupled with fed policy at the short end, ultimately drives yield curve fluctuations. [0] https://obliviousinvestor.com/wp-content/uploads/2012/07/yieldcurves.png https://obliviousinvestor.com/wp-content/uploads/2012/07/yie... [1] https://www.bloomberg.com/news/articles/2017-10-30/what-s-a-term-premium-and-where-did-mine-go-quicktake-q-a https://www.bloomberg.com/news/articles/2017-10-30/what-s-a-...

pishpash 8y ago

Where are you getting this 50% from? Also, you're ignoring that there is more price risk in long bonds even if you can sell them, so there should anyway be a term premium (upward-sloping curve) even if the expected interest rate over five years is constant.

sf_rob 8y ago

>Statistically that should be the case 50% of the time. Only if the risk premium is the same. >Treasure bonds are liquid, so buying a 5 year one does not mean that you have to hold it to maturity. Here you claim that the risk premium is the same because it's liquid. However the term is not the same so you'll be hit with a bigger effect when short term interest rates change on a longer time horizon instrument.

nickles 8y ago

There are a few factors that cause one to expect a monotonically increasing, concave yield curve [0]. Firstly, one must consider the term premium [1]. In short, you expect to be compensated more for lending money for a longer period of time. Consider lending money for two years. You could lend your money in two single year-long increments, in which case you would compound your gains from the first year when you lend out the second year. If you lend in a single, two year-long commitment, you rationally expect, all else being equal, to earn as much as you would have by lending as described previously. This drives the general upwards slope (or contango) of the yield curve. Next, consider a credit component. When you lend someone money, how likely is it that you are paid back? If you expect there is default risk, you factor that into the interest rate you demand. As the tenor of the bond increases, the risk of default increases. However, the extra interest you demand for credit risk also decreases as time goes out. Why? What are the chances that someone defaults on a loan between 5 and 10 years? Probably greater than the risk that the party defaults between 10 and 15 years. This drives the concavity of the yield curve. Finally, the movement in the curve is driven by expectations of future interest rates, as determined by Federal Reserve policy. Fed typically acts at the short end of the curve. In its tool chest, fed can manipulate rates like the fed funds rate, IOER, and ON REPO. As the economy improves, fed will raise rates. When economic outlook declines, fed will lower rates. If you expect that rates will be higher in the future, you will demand higher yields for longer dated bonds, since your invested money will earn less of a premium to interest rates in the future relative to where you invested today. On the flip side, if you expect interest rates to decline, you will want to lock in your money now, so you purchase longer dated bonds, since you do not expect to be able to get as high a yield in the future. This action at the long end of the curve, coupled with fed policy at the short end, ultimately drives yield curve fluctuations. [0] https://obliviousinvestor.com/wp-content/uploads/2012/07/yieldcurves.png https://obliviousinvestor.com/wp-content/uploads/2012/07/yie... [1] https://www.bloomberg.com/news/articles/2017-10-30/what-s-a-term-premium-and-where-did-mine-go-quicktake-q-a https://www.bloomberg.com/news/articles/2017-10-30/what-s-a-...