Is Kudlow Wrong?: What the Yield Curve tells the Smart Investor

How does the yield curve affect investments?  To understand this question, we first need to understand what determines the value of financial assets. The simple answer is the best. The value of financial assets is determined by the value of the future cash flows. For fixed income, the present value (PV) of the asset is determined by the future cash flows discounted at an appropriate compounded rate. The yield curve tells us the weight we apply to those cash flows.
The appropriate discount rate is determined by the spot curve, i.e. the yield curve. For example, for a flat yield curve, I discount future cash flows six months out at a similar rate as I would a ten or thirty-year investment. A steep yield curve would tell a different story. The more distant cash flows would be discounted at a higher spot rate. See the current yield curve below which is sloping upward - quite the norm. The most convincing explanation is that the risk averse investor will naturally require a greater premium for longer term investments.
We can also look at the yield curve to serve as a proxy for the time preference. A steep yield curve will indicate a market preference for shorter-term assets. A flat curve would indicate a shunning of shorter term investments. When the yield curve inverts, or goes flat. Run. Convert to Cash. It is one of the only things that I feel comfortable saying always do. Not every recession has been preceded by an inverted yield curve, but, according to monthly interest rate data from the Federal Reserve, nine of the last ten inverted yield curves has been followed by a recession or bear market (20% or more decline).

Does the Yield Curve Forecast Mini-Boom?

So what do you do if the yield curve is sloping?  Larry Kudlow has recently written that the yield curve steepness could lead to a mini-boom (see http://bit.ly/5mxWfK).  I disagree with his logic and his data.  He states that steep yield curves tend to be associated with stock market rallies.  He is right, but the devil is in the details.  A steep yield curve is associated with stock market rallies.  However, a steepening yield curve is associated with its opposite.  Just look at what happened to the stock market when it went from flat to where it is today.  Plus, the curve is not much steeper than since Bernanke first lowered short term rates to zero.  If the difference betweeen the short and long term yields rose to 5.5% then I would say we would be in for a boom.  However, getting from 4.25% to 5.5% could be brutal.  As the long-term yields for bonds increases, the PV of the cash flows for stocks, which are long-term investments, decreases in the process. 
The Current Recession: Brought to You by the Yield Curve

Stockcharts.com has an excellent visual display of the dynamic yield curve and how it has changed over time and how that correlates with the stock market returns (see http://bit.ly/8Ww2lV).  You can click on the animate button and see what has happened dynamically.  Note that the yield curve was inverted for some time before it actually fell. It was inverted longer than was typically seen with other recessions.
Financial institutions, especially banks use the upward sloping yield curve to make money. As the yield curve apply to both assets and liabilities, a bank can have short-term liabilities upon which they pay low interest rates, and long-term assets where they receive a spread in return for the risk they undertake. This often comes in the form of paying short term demand deposits and recieving credit card, mortgages or other longer term assets.  That is why an inverted yield curve is the kiss of death for banks. They can’t make money and often fold quickly and dramatically. In the case of the current recession, the yield curve was inverted for over a year when the crisis hit. As it turns out, the only reason they were able to survive for so long is because they offloaded their risk to hedge funds and refused to expand their balance sheet and effectively put off their day of doom.
How Exposed is Your Bank?

Which financial institutions are most exposed to interest rate risk?  When analyzing financial insitutions, pay close attention to Duration of Equity which looks at both sides of the balance sheet as if they were bonds and measuring their IR risk.  Any bank worth its salt will know this number and any analyst worth his/her salt will know to look for it.  Furthermore, analysts looking at banks need to understand the derivatives.  Banks balance sheet can be quite deceiving as they can swap out their longer term deposits in exchange for floating in a plain vanilla IR swap.  At GMAC, they swapped 1.5BB of longer term assets into 3 month floating.  If short term rates remained low, it translated to 100MM in Net Income, but the risk they took could have caused them to lose the same amount. 

For media inquiries, please contact Taylor Cottam, CFA, MBA at tcottam@yahoo.com or post comment.

Comments

Popular posts from this blog

October retail sales come in strong, especially auto sales

Tea Party Buffalo Pictures

How to spot a fake Tea Partier