Economics blogs are abuzz over the fact that the slope of the yield curve is at a record high. The difference between the yields on 2-year and 10-year Treasuries hit 2.75 percent yesterday topping its previous high of 2.74 in 2003, according to Bloomberg. As many, including myself, have pointed out, when the yield curve steepens like this, it’s usually a sign that the economy will be humming within 12 months.
But there’s good reason to think that this time it’s different.
This is due to the fact that when short-term rates are at -- or close to -- zero, they don’t reflect actual "market-clearing" rates. (That's why we hear all the talk of negative interest rates these days. As I wrote on Monday, some economists think in an ideal world, the federal funds rates should currently be close to -5 percent in order to get consumption going again.)
When short-term rates are close to zero yields further out on the Treasury curve don't convey the same information that they do when short-term rates are well above zero, according to a theory put forth by Fischer Black, best known for the famous Black-Scholes option pricing model. According to Fischer, investors will switch their holdings to cash if interest rates drop below zero, so a zero lower bound on interest rates acts as an option:
Let us look more closely at why the short rate cannot be negative. It is because currency is an option: when an instrument has a negative short rate, we can choose currency instead. Thus, we can treat the short rate itself as an option: we can choose a process that allows negative rates and can simply replace all the negative rates with zeros. We still have a process with a single number describing the state of the world: either the short rate (when it is positive or zero) or what the short rate would be without the currency option (when it is negative). We can call this number the "shadow short rate."
This process also affects longer-term securities so that their "shadow rates" are lower than their nominal rates. The chart below from a 2003 paper by Federal Reserve economist Antulio Bomfim illustrates this:
...the negative slope of the ... (dashed) yield curve suggests that the economy is expected to remain trapped in its low-activity equilibrium well into the future. Thus, we have a situation where an upward sloping (observed) yield curve is signaling expectations of a prolonged slump in the economy. This is exactly the opposite of the usual indicator property attributed to the yield curve!