The U.S. Treasury bond market has rallied strongly since October, but especially during the last 30 days. From Feb. 6 to March 4, the yield on the 30-year T-bonds declined 130 basis points, roughly the equivalent of $130 per $1,000 bond. Through the same period, the cost of overnight money as measured by the federal funds rate declined just 20 basis points. Concurrently, the yield on the 90-day T-bill fell 27 basis points.
The end result of these moves was that the yield curve, as measured by the yield spread between the T-bill and the T-bond, narrowed from 205 basis points to 103 basis points, even though the yield on the short maturity had hardly changed at all. This is all the more remarkable when you consider that the average spread for this relationship over the past 14 months has been 314 basis points. In the lingo of the bond market, "the yield curve is flattening."
According to Bob Giordano, an economist for Goldman Sachs, this "flattening" is unusual in that only about 15 months during the last 30 years has the yield curve flattened at all, let alone that much, without short-term interest rates rising.
Giordano offers several explanations. First, he refers to the institutional aspect in which state and local governments during 1985 sold $60 billion of "refunding bonds," the proceeds of which had to be invested in treasuries. This action, especially during the fourth quarter of 1985, had the effect of driving down the interest rates on longer Treasury maturities. Another type of institutional activity that helped push interest rates lower on longer Treasury issues was the massive flow of funds into bond funds during 1985. Eighty-one billion dollars of the $90 billion that found its way into mutual funds during 1985 went into bond funds. This flow accelerated when rates on small-time deposits at banks and thrifts began to fall. Investors began to reach for the higher returns available in bond funds which purchased long-term securities.
The most recent impetus given to the "flattening" of the yield curve was due mainly to two other factors. In the first instance, it is the perception of a "real interest rate." The real interest rate is perceived as the nominal interest rate less the inflation rate. In early February, the nominal rate on a 30-year bond was 9.35 percent. With the price of oil declining, analysts began to change their ideas concerning inflation for 1986 to 2 percent to no change from 3.5 percent to 4 percent. The real rate, therefore, became 9.35 percent minus 2 percent, or 7.35 percent. Historically, the real interest rate has been 3.5 percent. When investors saw a real rate of 7.35 percent, they went for longer maturities, driving those rates lower.
Finally, analysts expected the central banks of Germany and Japan to reduce their discount rates. When this occurred, it was anticipated that the United States would follow suit. This action then would reduce short-term rates in the United States, which would spill over into the longer maturities. With expectations having become a reality as all three nations lowered their discount rates, it remains to be seen if the flattening will continue or if yields on longer maturities have fallen as far as they can, for now.