Why are US long bonds more expensive than short term bonds?

Question

Why are investors currently willing to accept lower yields on a ten-year committment than a 2 year one? Is it because foreigners (big buyers of US treasuries I gather) are not allowed to buy the relatively short term bonds?

Answer 1

Investors are risk averse, and demand a premium for taking on more risk. Ordinarily, longer term bonds are considered more risky than short term bonds -- so they have a higher yield. This is because people worry about the price risk of bonds. If rates go up, the price of long term bonds goes down mor ethan the price of short term bonds.

But interest rate risk comes in two flavors. Not everyone is worried about price risk. Sometimes people worry about reinvestment risk.

Let's look at an example. Suppose that there are two investments available to you -- a one year T-Bill that can be rolled over into another T-Bill -- and a ten year zero coupon bond.

If you have a one-year investment horizon, then getting the bill will lock in an interest rate for you -- eliminating risk. If you buy the zero & sell it after one year, you could make a big gain if rates go down -- and you could actually lose money if rates go up. There is more risk with the ten-year.

However, if you have a ten year investment horizon, the zero coupon bond allows you to lock in your rate -- eliminating interest rate risk risk. If you keep investing in T-Bills, then you could end up with more money if interest rates rise, and could end up with less money if interest rate falls. You are exposed to more interest rate risk with the short bill than the long bond.

In order to get an inverted yield curve, you have to get a movement in the time horizon of the marginal investor from short term horizons to long term horizons. What causes this?

Campbell Harvey's doctoral dissertation test a theory first put forth by Doug Breeden. He found that when the five year bond inverts relative to the three month bill, then a recession follows in three to five quarters. What is happening is a self-fulfilling prophesy. Corporations fear a coming recession. So, instead of investing in their company, they invest in medium term bonds to hedge their bets. If enough companies do this, it drives down yields in the middle of the curve -- causing an inversion. It has another effect -- since all these companies are investing in bonds rahter than their companies -- in a few quarters, supply is down and GDP falls.

Answer 2

My only explanation is that people think that the economy is going to tank and that we will have recession and deflation.

Frankly, I think people are crazy to buy long bonds. The future is too uncertain and investors should not be willing to accept lower returns for more uncertainty. But they are. Amazing.

Either the bond market or the stock market is wrong in their evaluation of the future. I wonder which one.

Answer 3

because they are