The Interest Rate Conundrum

Alan Greenspan complained in 2005 that even though the Fed has increased the federal funds rate, yields on 10-year treasurys had declined rather than gone up. This decrease was considered unusual since increasing the fed funds rate represented a policy tightening.

Policy tightening means money is not as easy to get. When the fed funds rate goes up, the cost of borrowing money from the government goes up.

Tightening generally signals that the economy is doing well; for this reason you might expect 10-year yields to increase.

In 2005, the Fed raised the fed funds rate by 150 basis points but long-term interest rates were lower than short-term rates. All else equal, as short-term rates rise, so do long-term rates.

Historically, long-term rates rise in association with policy tightening.

In this episode, long-term rates (measured by the 10yr note) were declining as short-term rates rose, in a phenomenon known as a yield curve inversion.  When the money you can earn in the far future is less than what you can earn in the near future you are essentially punishing savers for saving money for longer. Normally you would expect to be rewarded for lending for longer.


A number of hypotheses were bandied about.

One was the idea of a “savings-glut”; because emerging markets looking for stable investments ended up buying tons of U.S. debt – with a focus on short-term debt. This caused upward pressure on bond prices (more demand, price goes up). As prices rise, yields fall.

A similar sort of savings infusion was also occurring through pension funds.


Others spoke of the leading quality of the yield curve; that is: the market was signalling a coming economic recession, pushing long-term rates lower. If investors believed economic slowdown was near it would be expected that the Fed enact loose monetary policy.

Basically, investors were expecting lower rates in the future because they expected a recession which would force the Fed to lower the borrowing costs of money to banks.


Interestingly, the bond market was signalling one thing…but the equity market was doing the exact opposite.  In fact, during the time the yield curve inversion was occurring, the U.S. stock market registered successive record highs ( as measured by the S&P and Dow Jones).

The U.S. bond and equity markets are the most liquid markets in the world and as such are considered to be the most efficient markets in which pricing information is transmitted. So what to make of these two behemoths sending conflicting signals at the same time about the direction of the world’s largest economy?

There were explanations for the equity market strength: it signalled the healthy balance sheets of the companies in the U.S. market.  The global economy as a whole was doing very well, and U.S. corporations were doing more and more business abroad.

A third explanation discussed a notion known as the “private equity put”. Private equity firms, flush with cash, were buying public companies and turning them private. Investors getting wind of this behaviour rushed to get their money in before these companies were bought out.

The exact reason as to why the equity market and bond market diverged may not be clear. However, the mixed signals heralded a global downturn that would be the catalyst for major financial system upheaval.




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