Wednesday, July 7, 2010

Correction on Prior Post

*Credit: Tjemme

I confused yield chasing with the effects of inverted yield curves.

The economics textbook explanation was a bit dry so I went and looked at a multi-year chart of the 30 year bond instead. If you go back to the early 1980s, the 30 year yield was hovering around 10% and hit a high of 15% in September 1981. Then it went progressively lower past 1984.

So, those investors who bought at double digit yields reasoned that rates were going even lower in the future. They bet that was their last chance to lock in rates before the bottom fell out. Past 1984, they turned out to be right.

So far, the current scenario does not look like a repeat of the early 1980s. Right now, the Fed is intent on keeping low rates for a while longer instead of tightening. This is not the correct environment for an inverted yield curve.

The 'move up the curve' does not put upward pressure on short-term rates. Chasing yield only in this way only works when long-term yields are higher. Chasing yield effect works by slowing pushing down the yieldcurve starting from the beginning. Inversion contradicts chasing yield.
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