Q&A: Long-Term vs Short-Term Treasuries, Spread, the Fed, Interest Rates

Reader Question: What is the correlation between 10 and 30 year Treasuries (Treasurys), or short term vs long term Treasuries?  What is the spread’s significance?  How is the prime rate affected?  How is the mortgage rates affected?

Question/Comment From Article: Implications Of The Federal Reserves Purchase Of Treasuries

There is quite a bit of information behind this question/topic, and a summarized article should be adequate for most investors.  However, it’s not a bad idea for investors to read further on their own, to get a more in-depth understanding than the information posted here.  This article should serve as a starting point.

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Yield Curve, Cost Of Borrowing (Money)
First, lets discuss the yield curve.  Wikipedia has a good definition of the yield curve in finance.  They define it as “the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency”.

Most of us already know how to calculate the yield on a debt instrument.  It is what the instrument pays per year, expressed as a percentage.  The yield is generally dependent on the period of time the money is invested in the instrument. Mathematically, investing for a specified period of time (t), gives a yield Y(t)Y(t) or just Y, is called the yield curve, and is usually (“normally”) an increasing function of t.  That means the longer money is invested, the higher the rate/yield (but it’s not always the case).  The yield curve can be known with certainty, only if a specific maturity date exists.  Otherwise, it is interpolated.

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Different For Everyone

Yield curves can be calculated to describe the cost of borrowing for different countries, institutions, corporations, etc.  Everyone borrows at different rates, which is determined by their credit worthiness.  Higher yields correspond to higher costs of borrowing, as a higher return is being paid to the lender.  Yield curves that correspond to government bonds (or Treasuries) are issued in their own currencies.  This is called the government bond yield curve or government curve.  The LIBOR curve or swap curve is based on the London Interbank Offered Rate (LIBOR), and is the rate banks use to borrow from one another.  Corporate curves correspond to corporate bonds. The mentioned yield curves increase respectively (lowest are government).  Yield curves also move on a daily basis as they are traded and reflect the market’s reaction to news, events, and investor sentiment.

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Increasing Yields With Time (Usually)

As briefly mentioned, yields are usually higher the longer the maturity is.  But also note there is usually diminishing marginal growth as well. The reason for this behavior is due to the market anticipating a rise in the risk-free rate.  Investors (lender) who delay investing today, may potentially receive a better rate in the future.  Long-term investments also expose investors to increased potential of risks that may impact the investment (unforeseen future events, etc).  So investors who are willing to invest their money today require compensation for anticipated potential rise in rates (if they were to delay investing) and risk associated with holding longer-term maturities.  To compensate, the higher interest rates are offered on long-term investments.  Since US Treasuries specify a fixed maturity date, the yield curve can be calculated with certainty.  Long-term Treasuries therefore offer higher yields.

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Long-Term vs Short-Term, Spread’s Significance

The economy faces more uncertainties in the distant future than in the near term, and the underlying notion of investors is that the risk of negative future events (adverse events such as defaults, and higher short-term interest rates) is greater than that of positive future events (lower short-term interest rates and other favorable events). This accounts for the difference in long-term and short-term yields, and it is referred to as the liquidity spread.  If investors expect greater volatility/uncertainty in the future (even if interest rates are anticipated to decline), the increase in the risk premium influences the spread and causes an increase in the yield.

For the most part, the yield curve has remained as an increasing one after the Great Depression. Investors expected the economy to grow in the future.  With growth, inflation generally rises rather than decrease (deflation) due to increased productivity.  See History of The Post WWI Recession for a related discussion of inflation and economic growth.

If short-term interest rates are higher than long-term rates the yield curve will be inverted. This means a situation where something like the 10 year Treasuries (bond) will be at a higher rate than the 30 year Treasuries. The market’s anticipation of falling interest rates causes such incidents. Therefore negative liquidity premiums or spreads can exist. However, the prevailing view is that a positive liquidity premium dominates.  Therefore only the anticipation of falling interest rates would cause an inverted yield curve situation. Significant inverted yield curves have historically been followed by periods of economic depression.  Economists use the yield curve to assess and understand economic conditions.

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The Federal Reserve (Central Bank) and Rates

Expectations of inflation also cause expectations that the central bank will attempt to slow down economic growth, in order to keep inflation at a stable and containable rate by tightening monetary policy (raising short term interest rates). Investors demand a risk premium (higher yields) for maturities associated with the future uncertainty regarding inflation’s impact on the future value of money.

Earlier this year, March 2009, the US Federal Reserve purchased billions of dollars worth of longer term Treasury as well as mortgage-backed securities.  Such a move creates artificial demand and causes the yield to decline.  The US Federal Reserve keeps the Feds Funds Rate on target by buying or selling Treasuries, mortgage-backed, and agency securities on the open market.  The Federal Funds Rate is the short-term interest rate which US depository institutions (banks, savings/loan associations, credit units, etc) lend to each other overnight, within the Federal Reserve system.  It is the main benchmark rate.  The prime rate is a short-term interest rate in the US banking system, and is tied invariably to the Fed Funds Rate.  Therefore a decline in the rate of the long-term government bonds (treasuries), affects other borrowing costs. Therefore, mortgage and other long-term borrowing rates will decline as well.

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For further reading, Wikipedia has a pretty good summary of the yield curve, and yield curve theories.
http://en.wikipedia.org/wiki/Yield_curve

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Feel free to post questions, comments, or topic suggestions.  Please also take the poll question on the sidebar to the right!

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Thanks & Happy Investing!
The Investment Blogger © 2009

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5 thoughts on “Q&A: Long-Term vs Short-Term Treasuries, Spread, the Fed, Interest Rates

  1. Hi,

    I”m having trouble getting replies for this.

    But first off, I want to thank you for taking the time to answer.

    Let me read this.

  2. I’m still not too sure regarding the mortgage rate movement. I realize the artificial ‘demand’ / ‘buyer’, which is just another way of printing money, and monetizing the debt.

    When that occurs, I don’t think the market is real and it really isn’t no more. No one would buy treasuries until the Treasury yield spikes, because the world knows the USA ‘must’ borrow money, and it seems the ‘only’ way. Other countries know this. My guess is, when ‘demand’ falls in ‘real markets’ (i.e. funds that invest in treasuries, or countries, i.e. China) fails to buy @ the auctions, then the “FED” comes in to prop up, creating ‘another’ artificial ‘demand’, to rework the yield down. So that the USA doesn’t get screwed too much. Who are we kidding, the USA could basically sell as much Treasuries to the FEDS and have ‘money’. They are just playing games in the media, which is quite apparent.

    In reality, I think Treasuries aren’t worth that much due to massive uncertainity, more so politically than in the markets.

    Maybe if you could write an example?

    1. Mortgage rates are tied to the Fed Funds Rate, which is influenced by the buying / selling of treasuries.

      However, you are absolutely correct. The purchase is in effect “printing money”, and is a short term fix. You are correct, there is an artificialness of it all as well. As discussed in the prior article, Implications Of The Federal Reserves Purchase Of Treasuries, the consequence will be sharp inflation. That is of course unless they can some how come up with all the money (real this time) to offset what they have done.

      It is yet to be seen what exactly will happen when the ‘demand’ falls in ‘real markets’. However, China which holds trillions in US treasuries will be very careful what they do, as they don’t want to unnecessarily devalue something in which they have a large holding in. Recently at one of the G7 summits or meeting of a similar type, one country raised an issue about having a different reserve currency other than the US (presumably due to what the Feds have been doing. i.e. printing money).

      So yes, the world does know what is going on. But at the same time they aren’t in such great shape to do much about it either. Treasuries and in turn, the US dollar is not worth as much, I think not due to the uncertainty, but due to the certain fact that the Feds have devaluated it themselves through their actions. They might not have had much of a choice, but they did do it.

      I’m not sure what example I can write to illustrate it more, but it seems to me your understanding of what is ‘really’ happening is pretty much there. I too ignore the media, which is whole other topic. =)

      You might be interested to read this article as well, which talks about the devaluation of the US dollar:
      http://theinvestmentblog.net/2008/07/15/how-the-financial-crisis-will-affect-gold-prices-us-dollar-inflation-oil/

    1. Hi Anticipate Opportunities. I’m not a technical trader, but I think that your technical analysis may prove to be correct regarding the TLT turning bullish, at least temporarily. I usually do not forecast short term trends though. But the Fed is again looking into another stimulus package, and may perform some more quantitative easing (buying of treasuries). That may indeed increase the buying demand again (bullish) temporarily in the coming short term. Nice site by the way.

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