Yield Curve Inversions and Monetary Policy

What can the yield curve tell us about the future path of monetary policy? The two standard theories used to explain the yield curve are the expectations hypothesis and liquidity preference theory. Under the expectations hypothesis, all future interest rates are taken to be equal to their market expectations. The theory implies that investors require no compensation in the form of a liquidity premium for holding long-term bonds, as the yield for a long-term bond is simply the accumulation of rolling over short-term forward rates. In other words, low long-term bond yields today imply market expectations for low short-term bond yields tomorrow.

Liquidity preference theory assumes investors demand compensation for the interest-rate risk in long-term bonds. If these investors are mostly short-term, they will demand a premium to hold long-term bonds, which will result in forward rates higher than expected future short rates. This difference is the liquidity premium. On the other hand, long-term investors will demand compensation for the roll-over risk of holding short-term bonds. This will result in forward rates less than the expected future spot rate.

Now what does this have to do with monetary policy?

Currently, the yield curve for government bonds in many countries is inverted. The yield on the 3 month T-Bill is 293 bp higher than the 10 year Treasury. There has been much speculation on this phenomenon, but a common view is that lower yields on long-term bonds incorporate expectations of lower short-term interest rates due to a Fed rate cut cycle. Cuts to the Fed Funds rate will ripple through to short-term Treasuries, dragging down their yields as investors substitute reserves for government debt. This accords with the expectations hypothesis. 

However, as Milton Friedman pointed out, the level of interest rates do not point to the stance of monetary policy! In particular, a successful Fed easing cycle in the face of a recession should boost long-term interest rates, as a higher growth rate of the economy in the future would lead to higher interest rates. The lower expected long-term rates of today point to expectations of an unsuccessful rate cut cycle that leads to monetary tightening in the future. This is reminiscent of the unsuccessful cycle initiated during the  financial crisis, where Fed fears of inflationary pressures led to a drastic tightening of policy during Q3 08.

 Liquidity preference theory points to another explanation of the yield-curve inversion. Supposing investors have a long-term outlook, they would demand a premium from the market for holding short-term bonds. This would lead to long-term bonds having a negative liquidity premium, which would invert the curve. Do investors have a long-term outlook? The savings-glut hypothesis, that the world is awash with cash from investors seeking retirement savings suggests an answer. If this hypothesis were true, one way out is fiscal policy. Increasing the supply of safe long-term assets in the form of government debt would help satiate the global demand for these assets and help boost yields.

 In either case, the inverted yield curve demonstrates the need for an energetic response from both the fiscal and monetary authorities in the event of a future recession. 

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