yield curves – the _

[2419] Japanese government bond yields during the 1990s

After reading my last post regarding the yield curve of the US treasuries, a friend asked if those curves replicate those seen during the Japanese Lost Decade.

The Japanese economy has been to where the US economy currently is. Arguably, Japan has not been out of it ever since the 1990s. Zero interest rate policy, or ZIRP, was popularized by Japan first. Because of this, a professor of mine quipped that “if anything, the Japanese central bank is more sophisticated than the Federal Reserve.”

So, how did the Japanese yield curves of the 1990s look like?

The year 1990 and 1991 were undoubtedly inverted, either reflecting or signaling something ominous was about to happen. This was after the Japanese property bubble. It burst and brought with it, the famed Lost Decade.

After those two years, the yield curve assumed some normality albeit some inversion in some years for some term in 1993 and 1995.

(Some of the curves do look too flat and that is because some numbers are missing from the Bloomberg terminal. I took the liberty of imputing average of the nearest readings to make the graph looks pretty.)

The curve continued to flatten over the years into the next decade. By 1996, Japan was very much running ZIRP.

The flattening of the Japanese government bond yield curve, or really the general shrinking of the curve to the point seen in the late 1990s offers a starkly pessimistic reading of the fate of the US economy.

Nevertheless, it is a kind of fatalism to assume that is the ultimate fate of the US economy. Right now, the yield curve in the US is still steep, although it is flattening (notwithstanding the talks of “Operation Twist”).

[2413] Looking for inverted yield curve

There have been talks of recession hitting the United States again. Extremely shocking manufacturing data from the US today is probably partly fueling the talks.

Although prediction is a risky game, there are various indicators one can use to gauge the likelihood of a recession. One of them is the US treasury yield curve.

An inverted yield curve may signal a recession, or at least some kind of pessimism in the market. The reason is that market participants will expect rates to go down during a recession. Future inflation rate meanwhile is expected to decrease as demand dies down. With those expectations, the bondholders will not require too high a returns.

Now, despite the talks, the current curve is sloping upward.

As you can see, the three yield curves in the last few weeks have been well behaving, unlike the one about 3 years ago just after the peak of the financial crisis. The September 2008 yield was inverted up to 2-year term.

So, there is no recession in the current yield curve. At least, not yet. Quite the contrary (unless we will be seeing stagflation), there is considerable inflationary expectation beyond the 5-year term relative to now; it is a pretty steep curve. That may suggest some kind of recovery.

Nevertheless, looking at the yield curve right now might be flawed, just because the Federal Funds Rate is already close to zero. Given that the US is possibly in a liquidity trap, the yield curve cannot be inverted.

Still, a relatively flat curve could be used as a signal of recession, especially if liquidity premium theory is taken into account. If the curve keeps sinking like it has for the past few weeks (so far, it seems to be due to flight to security phenomenon), we could be seeing a flat yield curve in a couple of months. Then, the case for recession will be stronger.

Of course, the curve should be viewed in context of other data for one to have a more educated guess about the future.

Another story is that the yield curve has been sinking lower and lower. The market is telling S&P something: S&P has got it wrong.