Financial Markets and Institutions - Test

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Overview, Objectives and Readings

Overview

Page 1 of 1

I nterest rates are closely related to the amount of money available for borrowing and lending. We'll consider the components that make up the amount of loanable funds, as well as how the supply of and demand for loanable funds influences the interest rates paid by DSUs to borrow money from SSUs.

The relationship between interest rates (yields) on particular securities and their terms to maturity will also be analyzed. This relationship is called a "yield curve" and can be helpful in understanding where the economy has been and may be heading. Our objective is to gain a thorough overview of how interest rates adjust to the amount of loanable funds available, essential background for our upcoming discussion of monetary policy.

Please be sure to stay on top of the the Faber material in advance of next week's quiz.

Objectives Readings

After completing this module, you should be familiar Week Five Readings with:

Read chapters 5 and 6 in An Introduction to Financial Markets • The functions, properties, and types of money being and Institutions, 2nd Edition by Burton, Nesiba, and Brown

used to facilitate exchange • The relation of money and prices and the impact of Continue reading the prologue and chapters 1 through 6 of changing prices upon the U.S. economy And Then the Roof Caved In by Faber

• How the money supply and credit are measured and the insights these aggregates provide

• The relation of loanable funds and interest rates, along with factors influencing the term structure of interest rates

• How the yield curve can be used to analyze the possible direction of future interest rates

https://ool-content.walshcollege.edu/CourseFiles/FIN/FIN3 l 0/ssholty/FA 14/Week05/00... 10/30/2017

Functions and Properties of Money

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Lecture Overview

■ Functions and Properties of Money

■ Types of Money

■ Measuring the Money ~ ' "°~

Supply ~~, ■ Money and Prices ~~;>

■ Money and Interest Rates

■ Term Structure of Interest Rates

What is Money? ■ Medium of exchange

■ Eliminates search casts associated with barter trade

~', __

~~__ ~_

Notice: The number of

coincidences had to have happened for an exchange to

What is Money?

■ Allows for division of labor and specialization

~~Promotes productivity and _ '~ ~;:~ wealth creation ~ ~ . - ~4

,_ ~\ _ ~ . ~~ ,

What is Money?

■ Commodity with the widest market appeal

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■ Various commodities have .i^i~ ~

.~~.~-~ served as money ` P^

Salt ~ .... ... ..

C ws ~̀~b

~~~s~-

-.-'''pppppp,,, Tobacco

T ~

~ ~.. ~. a:x r`

u 4

What is Money?

■ "Modern" money still takes many forms

,,. -- _ .--~

Currency and COins ~ ~,?

~~ ~. Checkabt8-depoe4tS '~~ z~

_ _._ i /

`+ Savings accounts

Functions of Money

Medium of Exchange

❑The exchange asset most generally accepted as payment for goods and services Recall•Salt

Store of Value

❑Preserves wealth by transforming other assets into something of permanent value

Standard of Value ❑Provides a common standard to compare the value of different items

Functions of Money

■ Serves as a unit of account

■ Promotes optimal resource allocation through the pricing mechanism of the market

The Functions of Money Medium of Exchange A m o/ paY^~nl: sonielhing

5ed in bansaclions

~o make payments

Unit of ~1 1 ~ ~`.,.~~

Account The accounfny unt

o. s~a~da~m~ee

~ y

e or awe ~~ - -i~" wh ch prices are

Store of Value

Something that retains its value if held

Properties of Money

Desirability o That item for which everyone • - will accept payment

❑ Preserves credibility and SC81'City purchasing power by not - - --

being freely available

Durability ❑Maintains value over time, allowing impermanent goods to be transformed into more lasting value

~i:

Properties of Money

Portability Convenient and practical; easily transported

Reliability ~~ Assurance of genuine,

___ reliable, and exact value

Divisibility Makes small exchanges possible, putting everything in reach of a monetary transaction

Types of Money

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Types of Money

1. Commodity Money

Intrinsic and instrumental value ~ A J~~~~

Intrinsic value =cigarettes can ~, ~ i be smoked

Instrumental value =cigarettes can be used as money

Types of Money

1. Commodity Money

<`~ ran' 't" Coined form is called „~ "specie currency" ~~~ :~ ;~.~ l

Carries the full value of the ~~~ ~ commodity with additional portability

Types of Money

1. Commodity Money

Uncoinedform is called "bullion"

Advantage to commodity money is that it preserves its value overtime

~~..

~~~/~ ~:

Types of Money

2. Fiduciary Money ~"='~ ~ ~

$ .~ ~ .. ~ A claim against other - forms of money ~:,~ ;

~̀ +~ 1 ' j ;

_n.~. _. _._ ----r-- ~ - - -

Types of Money - ,_., .

2. Fiduciary Money i Its value '" because

Instrumental value only ~ of its (no intrinsic value) usefulness!

z~a ~sc~ax:: =:~ .i

"' t~ f Take to ~ _ },~~ ... ~- bank.~ _ ,

4 ~

Types of Money

2. Fiduciary Money

Checkable deposits most common form

Originally backed by commodity money, but now mostly backed by fiat money

~~_ ; . `~

~~;- ~~t ~.. ~ w~:.

Types of Money

3. Flat MOne)/ ' Let there' be!

Power to cancel debt ("legal tender")

Created and controlled by governing authority ,i

Instrumental value only ~~p,

• Receives its instrumental value directly from the Government

Types of Money 3. Fiat Money

R@CBII: Redeemable ~! ~

~'.`7~ P

K~~

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Types of Money ,,

~r~~~~~ Backed . ,

by , .

FldUciary Money J~ ~

<~~~ dyy......_.. .. ti . ~1tl~~'`,°""~By4̀ '~". Pros: Readily available

4 ~~..

"̀ .: Cons: Subject to excess creation Fiat Mone

Measures of Money

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Measures of Money The U.S. money supply is

measured using "monetary aggregates"

❑These include: ---~,~ ■ M-1: The most restrictive measure ' ̀~- ~-"- '

■ M-2: Slightly less restrictive than M-1 I

. M-3: The most inclusive measure

■ The Fed also tracks an important non-monetary aggregate called "DNFD", DNFD: DomesticNon-Financial Debt which is a measure of debt

Measures of Money M-1

❑"Narrow" money ❑ Money in purest medium of -!~ exchange capacity

❑Can be spent immediately

❑ Referred to as "transaction money"since it can be used •-~~ ...,. n,_ ;, _ . :. "as is" for making purchases and payments

Measures of Money

❑ M1 is the most liquid measure of money

_ ~:* : ,~-

~~~r

Currency in culation Checkable deposits Travelers checks

❑ Most M-1 is created by private-sector depository institutions

❑ Majority of M-1 money consists of checkable deposits y

Measures of Money

M-2

❑ "Broad" money

❑ Only slightly less liquid than M-1

❑ Referred to as "near monies"; easily converted to transaction money

M ~ -'- ~.I

Savings de osils ,'.'sa•~~ ~Y~'"-;

Small time de osits ~~,r`

Mone market accounts

Measures of Money M2 -Example

-̀.;~, ■Pay with:

' ~ M-1: Transaction ~ Cash

~,~ ,~ ̀ ❑Check .....Money._....,

e~~ ~~~~`~'~'' .......

~ check

ers

What about saving deposits?

~ : t~

Measures of Money

What about saving deposits?

■ Transfer funds from """~'¢ savings deposit to

your checking Options: account

,,~ ~: - - - - ■ W ithdraw cash from ~~' ~- ,_._ _ savings deposit

', This would be similar process if it were a CD versus saving deposits.

__ _

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Measures of Money

M-3

❑ Most inclusive measure of items considered to be money

❑ Cannot be used "as is" for making purchases or payments

❑ Less liquid than M-2

M-2 JY

Lar etime de osits

Institutional mone market mutual funds '"i~

Measures of Money

M-3 issue is that it is further away from transaction money than M-2

■ For example: Large time deposits '! ❑ Transferrable into cash but wailing is longer with a - - ~ ~+ larger CD

M-3 is still money but it is the most inclusive measure!

Domestic Non-Financial

Debt

~ Greg Todtl X110 WakM1 COMgt

~i .

Domestic Non-Financial Debt

Domestic Non-Financial Debt (DNFD)

An important non-monetary aggregate measured by the Fed

■ The amount of debt incurred by domestic borrowers

ExdUdes the ■ Purchases being made by credit as ` debt of opposed to money purchases ~ financial

i nStilu~ions ~ as well as

debt if̀oreign ~~

_. ~ //

The MonetaryAgpreqatesas of 2008 r~s~~~~o~5o~oo~~a,s> ~~~~~

Fed no lon ger provides M3

ti___

r,.~ w~•

r«.i x:

~he Relative Size of the Monetary Aggregates'` and DNFD as of 2008

• V i I ~I,<i~ ~0

t M.Ol4.M ~'. ~'N11:.. __

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nnu~.w'_T.—_.____________ 4r,M.t~

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1 fs,on mi _ .

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The Monetary Aggregates and DNFD, ~~ 1965-2007

nm+- ------ --------..___----

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~— Y.1

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n _. - .,_,..,-Tr,~.,,,.,..~

S ~.•.~...c o a >> g c 5 e o S c

€ 3~ ~K~~s"s3"a~a"~"s

Monetary Aggregates and Domestic Nonfinancial Debt 8/201: .~ :vn...y r m, me. d r. a~ s wz~

o~.a ~i: ai ~o,~m~mi a.xd ~i. ~

oms rn«wek eeo~. (tiros+• ow .a~ e...u~aaw~ M uH cnecw rrrq~ TAs

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rxso v.a.ar c..a m.ne as a m. us. w+,•~.~~ a,4. aye au a~,•^.e. ~wdr. sere.. ~wq~x+. ~ew~~R ~m.m~w a.~x ~s s~vyo

rvoa.e~.n oib w a... ~o,r~s~ >

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Monetary Aggregates and DNFD

_... _., :x~3F~., t~[M~.>61bnd 19 .... ..

oew~ ie._. .... the te4 to SEe ~~•_... n. ~w.

IS .... .......

i 11 .......... lIX:i '.n Ii:~~n N

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it .......... ~,::.' .. ... i ~~ .. .... .. ..

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y .. ...... t e _ _ 1)A)f <..

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Monev Aaareaates and DNFD ~'.

Money and Prices

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Money and Prices

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~~ ~ ~~ Af̀`'ar

Price Inflation . Is the effect

Monetary Inflation Is the cause ~~ y,_,.. ,

Money and Prices

Price will increase when:

Money Supply Goods and Services 1

Price will decrea

Money Supply Goods and Services

Money and Prices

I nflation

❑ Arise in prices caused by an underlying increase in the money supply in relation to goods and services

❑Three consecutive Y~~'~•s quarters of rising - - - consumerprices

Money and Prices

Deflation

❑A decline in prices caused by an ~ underlying decline in ~ ~. ~ the money supply in ~ ~ •`. relation to goods and services ~

❑Three consecutive '^ quarters of falling ' consumer prices

Money and Prices

Disinflation

❑A decline in the level '~ of price inflation, not to be confused with deflation

❑Three consecutive quarters of declining price inflation ~-----------= .

Money and Prices

Four Illustrative U.S. Monetary Periods:

1. 1879-1896: Deflation

❑ Fallen prices known as the secular price decline ° ~"'°„

-- ~~:..~ ~~_ - _;

l̀

Money and Prices

Four Illustrative U.S. Monetary Periods:

1. 1879-1896: Deflation ~~~p~'~E~"

❑ Unemployment — 2% ti"'Y~y~"''` ❑ Prime lending rate —1.5%

~t02% ` 2%

❑ Mortgage rates — 2% ❑ Average economic growth

rate — 3.9% per year ❑ Money supply expanded — ,

2.5% v

Money and Prices Four Illustrative U.S. Monetary Periods:

2. 1921-1929: Price Stability

❑ Greater economic growth than previous history

❑ Prices were stable due to the money supply was being increased as fast as the increase in the goods and services

. --1 ~ ~~ ,,~ ~

Money and Prices

Four Illustrative U.S. Monetary Periods:

3. 1970-1980: I nfl at i o n

❑ Federal government began increasing the money supply significantly ~~

❑ Result in double-digit ,,` inflation and double- digit interest rates _ -

Money and Prices

Four Illustrative U.S. Monetary Periods:

4. 1990-1999: Disinflation

❑ Began this decade with higher inflation rates than ~ the last decade ~`~.:.~

❑ Experience price inflation .l~ ~; but less of it as the years passed _

Measures of Price Inflation

............ ....... KC+M TodA M110 ~....... WrtM1 Colge I Clickf~Below io Begin Pfesen~atfon.

Measures of Price Inflation

Provide a gauge for the severity and direction of price inflation

Consumer Price Index •Replaced by CPI-U in the late

(CPI) 199os

. Both CPI-U and PPI are published

Producer Prlce IndeX monthly by the Bureau of Labor ~PP~~ Statistics (U.S. Department of

Labor)

Pel'soltal CoYlSUmption •Calculated using PCE information

Expenditures Price Provided by the Bureau of

IndeX (PCEPI) Economic Analysis (U.S. Department of Commerce)

Consumer Price Index (CPI)

Commonly referred to as the "Cost of Living" index

i Reports changes in the price of a representative i "basket' of consumer goods and services._ ..... __

❑ The "basket" represents — purchases being made by an average U.S. house

❑ Adjusted by the Department of Labor approximately every ten years

■ The "core rate' excludes the food and energy sectors, which tend to be more volatile than other consumer items

CPI-U CPI for "all urban consumers"

Implemented to correct potentially "overstated" levels of inflation as reported by the old CPI

■ Hssumpcion: vnaer inriauonary conanions, consumers replace more expensive items in their representative basket of purchases with less expensive items

Steak to Hamburger

Movie Theater to DVD Rental

Long- Distance Vacations to Day Trips

~ CPI-U attempts to reflect these changing consumption patterns CPI-U has been criticized for understating inFlation

FIGURE 73

Inflation Calculated Vndcr tht Old CP) Compared

with, In~arion Calculated Under the Nc~ CPI 2001-0

Alrmiata CY! Mtarunr Yeurv[o-Ymr Change,

Not Sensannlly.tA)wsrM, m Aaguir ]00:

aw -- -- - ---

I S ~~ ----

t -- Vrt-(SMmmfA~~ (Miaiil CP1-U-

'0! 'OL '03 'Oa' 'OT '06 'O: swm..wea+.ro.vn.w Ad*u.~ un.w~ N4ibw s.+m.fc.

om: Kcvn PMpq 8eC Mummy: Rerltbu Fiwcs, HiM PaYci, sM Xw G60✓ Case W Ame~lcn GpNsm (w.w Vak. Ukn9 Pa^A~n. NOsI. P N.

Producer Price Index (PPI)

Published monthly by the U.S. Department of Labor ~

Reports changes in the prices charged by

producers of goods at the wholesale level.

■ Does not include the price of services

(,~■ Producer (wholesale) prices eventually become part of consumer prices ; ________..___

■ The PPI is a leading indicator of future consumer prices

Personal Consumption Expenditures Price Index Tracks domestic spending on durable goods, non-durable goods, and services purchased for personal consumption.

■ Factors in recent price changes «_ before comparing to the index _¢ ~,, base ~a~ r :~

■ The Fed's preferred method for .. ' measuring price inflation ~ ~~`~

❑ Actively used in determining monetary policy

Money and Interest Rates

_ EGrM TMrl ::iii .

i Click~8elov.~to Begin Presentation. w'k"c̀ ~'~

Money and Interest Rates

■ Interest rates are closely related to the a

'. ~ ey

~ ~ an r r to i

■ Interest rates can be considered as "the price of borrowed money"

Money and Interest Rates

■ Interest rates are constantly adjusting to the amount of loanable funds available

An inverse relationship:

As funds increase Rates decrease

As funds decrease ~ Rates increase

Money and Interest Rates

Loanable Funds Components

Savings Contribution by depositors in return for interest compensation

• Checkable funds created on the

Bank basis of reserve deposits by

Credit fractional reserve banking.

Change in the turnover of the existing money supply

Velocity of Both depository and non- Circulation depository financial institutions

contribute

~̀f

Money and Interest Rates

■ The Fed carefully targets interest

rates in an effort to "steer" the ~~

economy

Sluggish Economy The Fed will increa:

thisthe amount of loanable funds

lowers

available ~~eerest

l rates ~ ~

i The Fed will ~7his

Overheated Economy decrease the .eases amount of loanable ~ ~nierese funds available rates j~.

I nflation and Interest Rates

Real Interest Rate Nominal Interest Rate

• The rate of •The rate of interest interest including the inflation excluding the rate inflation rate

■ If the real rate of interest is 5.00°/a and the

i nflation rate is 3.50%, the nominal interest

rate will by 8.50%

Lending Patterns Under Inflation

Complete I d

Illusion ~ ~i ;-~.:~~,', 5.

• `v~ .R.wY11F ~Y

Adaptive Lag (This pattern began in 1 the 1960s. J

Rational - ~r ~~~~~~c~~~~~ ~y pattern began

Expectations c from the late d, 1960's through ~

Ir the late 1970's.

- _~~t'

I nflation and Interest Rates

Other Interest Rate Factors Non-monetary influences

upon interest rates:

Credit Borrowers are assigned Rating different risk classifications

Taxability Earned income is n ot

taxed uniformly

Law and Securities are subject to

Re ulations9 differing legal.and regulatory policies

Security Differences &Interest Rates

Three Month T-Bill

■ Low inflation risk ■ No default risk ■ Highly liquid ■ No state &local

taxes ■ Not callable

20 Year Corporate Bond

• Long maturity

• Higher inflation risk

• Some default risk

• Less liquid • Fully taxable

• Possibly callable

Term Structure of Interest Rates

The relationship of interest rates and

maturities for a group of similar securities

is known as the term structure

■ For example, we can analyze the term structure for all U.S. Treasury securities

■ Knowing the term structure of ~, i~;;~,~. interest rates helps us to make more informed borrowing and investing decisions

Yield Curves

f—

...... .. ................ .___......_ ¢c.nraad mio ClickBBelowlo Begin Presentation. w'k"c°k"`

Yield Curves

Graphic representations of the term structure of interest rates.

Graphed for many different types of securities. ,. ,

• U.S. Treasury securities _ •Corporate bonds ,;:t~ ~, •Municipal bonds P~-~

Treasury Yield Curve Graphs the relationship between interest rates and

maturities for U.S. Treasury securities _._.

Treasury Bills (T-Bills) = Matures: 3-mo, 6-mo,

short term debt and 1-year

Treasury Notes = Matures: 2, 5, and

~intermediate term debt ~ 0-year

Treasury Bonds =long term Matures: 15, 20, 25, debt and 30-year

Treasury Yield Curve

Routinely reported in

•The Wall Street Journal

•Bondtalk.com Crick to visit~ _ -- --- -

Track Treasury Yield Curve changes

G irk ~~~ F3elow to Continue Presentation.

Yield Curve Shapes

• Normal

• Upward sloping • Yelds for longer maturities are higher than for shorter maturities

Maturity

Yield Curve Shapes

• Inverted

• Downward sloping • gelds for shorter maturities are higher than for longer maturities Maturity

Yield Curve Shapes

•Hum

•Upward and downward sloping •Melds for intermediate maturities are higher than for both shorter and longer maturities

Maturity

Treasury Yield Curve Source Bondh ~ m

Trwaury YHItl Curoo a --__

_.. .._.. ,_,..

°ice ~._.... __

-..6 -_._:.__.. ...... ___....._.. _..._.

~:n _ ~a

_.. a.at...._' "__. _..

~ ' . ..: ~. - _.

i _

Z ... _ ,...~..~.'~

.. iai _..._.._. __ .............."__"...__...,..~._. ~.a' /~

.run fb to t~.rt r.a +ataeR ~, toa 1cN 1F

CIIC{(t0 VISIt

Click below to contlnw

Corporate Yield Curve

Corporete Yield Curve 6 .. —"'__ ~ __ _.

S IS --__ _. .~,.--_ M- 55 25 5 ~~ )S - S:_'_ — - 2~

1.17 ~-~ _ !.ri ----

2.~.. ... .. . .... . .._- ._.___-

F' 6'

tN +M +pq

Source: Bondfalk.com

Municipal Yield Curve

Municipal Yield Cune

H ~_._ .~ .'___

-'~— ,yJ _._. ..

~....~ _ T~

l 13 _ ~ fo .-.__

S ~_.. __. ~-~

~ (~ _

1.7! . _.. _ _ .,

t __ _....~'._'__4z x a

(Municipal Bonds -tax exempt Nominal rate is lower E(tective rate is higher

Term Structure

u. •a .~r:.•.~<

~̀~. __

Long and Short Term Interest Rates

H '

1 1~,

~~ ~< <<. Thls Is the only time the short

teen rues did

r.+'.~ not rise above

~ the long term

•̂ - '•' tales

• The shaded areas designate ecorpmic recessions

• Short-term rakes are measured by 3 - 6 month loans to large, credit-

worihy corporations, arW long-Term rakes are measured by AAA borWs.

Yield Curve Influences What influences the shape of the yield curve?

Pure Expectations Theory

The shape of the yield curve is influenced by investor Inverted expectations concerning future .D i nterest rates ~

~ Interest rates rise =Higher } . return on investments

Interest rates decline = Yeld Maturely

curve becomes inverted

Alternative Yield Curve Shapes

} }

MaNrity Malunty Maturity

A rise o change: A decline

expected expected expected -

Yield Curve Influences

Liquidity Bias

The shape of the yield curve' is influenced by the need to y compensate investors for sacrificing liquidity over the holding period

MaWn~y

This is wby yield curves have a normal tendency to ~~

i slope upward'

Role of Liquidity Premiums

YxWw ~~~Ybtl Gr~c lC)•!• _~Muwlq

M•nWnn

✓. ~~.

YIJA Curve 6~uJ a~ [aa•~uvru IA1

Yield Curve Influences

Preferred Habitat

The shape of the yield ~

curve is influenced by the ~"

demands of dominant The expression of

mss aom~~a~~

investor groups for 9~oup for different

investment needs

preferred maturities would he reflected by the shape of the

yield curve.

Preferred Habitat

Commercial ■Prefer shorter-term Banks maturities

Life Insurance and Pension ■Prefer longer-term

Firms maturities

Casualty and Health ■Prefer mid-term

Insurers maturities

t re.~r~ow~~~~:~~r~.,l^ J

Yield Curve Influences

■ Yield curves are probably shaped mostly by:

I nvestor expectations of future interest rates

I nvestor compensation for lost liquidity

■ Assuming liquidity bias remains constant, the yield curve can be used as an excellent gauge of future interest rates

Dead Presidents Ever~,rwl~ere~ '1 know 1 know — Narotkon and fronkNn wrrodt presidents...

Millions of bills and coins trade hands each day in America, while many more are lost and destroyed. We Zook into how much paper currency is in circulation today and some interesting facts surrounding the U.S. Mint's production.

VALUE OF PAPER CURRENCY IN CIRCULATION as o(Dec 31,1008:

S7 S2 55 $10 $20 $50

$125.1 Milton

- - $b4.7 billion

$9.5 $1.7 511 $16.3

bilifon billion billion billion

..: .. ___-

>._. _ .,:

9.5 billion

l.$ years

$625 billion

20~8TQTAL: $853.2 BILLIt)N Includes Federal Reserve notes, U.S. notes and cuaency no fonge~ issueA

NUMBER OP BILLS IN CIRCULATION

1350 2.2 1.63 6.26 1.29 G.25 «zillion billion billion billion billion billion

LIFE EXPECTANCY nia 13 years 1.5 yeas 2 years ~~.6 years 7 ~a years

1.65 trillion

Do you know how moneyyou are? ■ Between the Fort Worth,Texas, and Washington D.C. facilities, approximately 18 tons of ink are used per day.

WesMegfon D.[.

tort Worth

■ During fiscal year 2008, the bureau of Engraving and Printing produced approximately 38 million notes a day with a face value of approximately $629 million.

■ Ouring the 2008 fiscal year,the Bureau of Engraving and Printing delivered 7.7 billion notes at an average cost of 6.4 cents per note.

t1.S.CURRENCY paper is composed of 25%linen and 75%cotton.

$500 to $10,000

$300 million

vari~'i,

.° M ~:a€rr re.rutiF~1P ~~a~~r~~ ~ ~~.

,~ ,~~

i • ~i,.,;. ..~ ,._ ~~.~,~-"

PENPIY

►fie.

NICKEL 2.5%copper

Y ~::

25%nickel

~ `= t ,

r ..

. . ~~.

97.5°lozinc 75%copper

2809 CIRCULATING COIN PRODUCTION in mrlllons of coins, year to date, 2Q09':

tl 5t 101 25C 50< $1

379.12 million 3Z2 98

million

Presidential 271.88

146 million 86.64 m~ilion million Native

3,q American miltior~~ 51.1

` ~ _ _ ~ ~— m(Ilion

~TAL:2.585 TRILLION i'~::SW PCE US.Depxtmeni d she Tre+wry '3ctimirwry praJuctmn llq~.•n on(y iii

i, '~ stock-market-crash.net

The Dutch Tulip Mania (or "Tulipomania")

By Jesse Colombo

http:/!www.stock-market-crash.neUt.ulip-mania!

Tulips have long held a significant role in Dutch history and culture ever since

they were introduced to the Netherlands from the Ottoman Empire in the

mid-1500s. So strong was the Dutch love affair with tulips during the Dutch

Golden Age of the mid-1600s that a tulip bulb bubble or "Tulip Mania" even

occurred. Generally considered to be the first recorded financial bubble, the

Tulip Mania of 1636-1637 was an episode in which tulip bulb prices were

propelled by speculators to incredible heights before collapsing and plunging

the Dutch economy into a severe crisis that lasted for many years.

Events Leading Up to the Tulip Bulb Bubble

The Golden Century is the name of the period in Dutch history between 1600

and 1700 when the port city of Amsterdam was one of the richest of all cities

in Western Europe due to its strong role in international trade. Trading companies such as the VOC (Verenigde

Oost-Indische Compagnie), commonly known as the Dutch East India Company, became dominant players in

the Netherlands'trade with Indonesia and other far-away Iands.Amsterdam's booming economy led to a

flourishing of the arts and architecture, as well as trade in blue glass, china and other luxury goods.

Dutch trade with foreign lands led to the importation of exotic goods that were never seen before by

Europeans. Tulips were first introduced to Europe from Turkey when a sultan sent bulbs and seeds to Vienna.

Shortly after 1554, these seeds were sent to Amsterdam, where their popularity began to rise.Auniversity

study in 1593 led to the discovery that tulips could withstand the harsh northern-European climate, which

further boosted their desirability in the Netherlands. With their intensely colorful petals, tulips were unlike any

other flower popular in Europe at that time and having tulips growing in one's garden became an important

status symbol (The Tulipomania, n.d).

Tulip plants originate in the form of tulip bulbs which do not flower until seven to twelve years later. Between

April and May, tulips bloom for about one week, with bulbs appearing between June and September, thus

confining Dutch sales to that season.Arudimentary derivatives market, similar to modern-day options and

futures contracts, eventually arose so that traders could conduct trade in tulips all year round. Traders entered

into tulip contracts by signing contracts for future tulip purchases before a notary. The very active tulip

contract market eventually became an integral part of the overall booming Dutch tulip industry.

As the Dutch tulip market became increasingly sophisticated, tulips were classified into groups and priced

according to their rarity. In general, solid-colored tulips were worth less than those with multiple colors.

Couleren was the classification for solid-colored red, white, or yellow tulips, rosen referred to multi-colored

tulips, often red, pink, or white and violetten described the white tulips with purple or lilac on them. Bizarden

were the most popular tulips, with a yellow background and red, brown, or purple coloration (Allan Bellows,

2012). Tulips that were infected with the benign mosaic virus, which caused "flames" of color to appear upon

the petals, sold at a premium due to their unique beauty and rarity (Investopedia, 2012).

The Mania Phase

Tulip prices steadily rose with their growing popularity and bulbs

were purchased at higher and higher prices by speculators who `'" ~" ,~~~gpp~ ~~~~~, L~

planned to turn around and sell them for a profit, similar to modern- C~=~r.. 1 , 1~:_i~tc~ FUb.5.1~37 ~

day house "flippers." From 1634 to 1637, an index of Dutch tulip ~'' ~~~'"~`~~~,~'s"a~"`~""`~1̀R ~~

prices (see chart above) soared from approximately one guilder per ~ti

bulb to a lofty sixty guilders per bulb. Traders who sold their bulbs i 9

for a profit began to reinvest all of their profit into new tulip bulb 1g ~`'

contracts or new bulbs to sell to other Dutch citizens or to take with ~~ ~ ~

them on trips around the world to sell alongside with spices from the ~ ~ i

Dutch East India Company. Many merchants sold all of their '~ ~,~ ~ I

belongings to purchase a few tulip bulbs for the purpose of ~ ', ~ ~ I

cultivating and selling them for more profit than they could have ever ~'''

made in a lifetime as a merchant.As the tulip bulb bubble ~,'~ ~ I~

crescendoed, already pricey tulip bulbs experienced a twentyfold

,,,~. ~" a '

price explosion in just a single month (Investopedia, 2012). By the ~r ~o ~,

eak of tuli mania in Februar of 1637 a sin le tuli bulb was worthP P Y 9 P ~' Q̀~' ~'~''`''a'-¢ ~"i'~m''"°"' '¢~"d '-''fl~,3a. ~c~~s yis~e ~~;~

about ten times a craftsman's annual income and a single Viceroy

tulip bulb was allegedly exchanged for the following goods (The

Tulipomania, n.d):

• Two lasts of wheat

• Four lasts of rye

• Four fat oxen

• Eight fat swine

• Twelve fat sheep

• Two hogsheads of wine

• Four tuns of beer

• Two tons of butter

• 1,000 Ib. of cheese

• Acomplete bed

• Asuit of clothes

• Asilver drinking cup

Successful Dutch tulip bulb traders, the archaic counterparts to the day traders of the late 1990s Dot-com

bubble and the house flippers of the mid-2000s U.S. housing bubble, could earn up to 60,000 florins in a

month- approximately $61,710 in current U.S. dollars (Allan Bellows, 2012). Tulip bulb speculation became so

widespread by 1636 that they were traded on Amsterdam's Stock Exchange and in Rotterdam, Haarlem, Leyden,

Alkmar, Hoorn, and other towns. Around the same time, tulip speculation even spread to Paris and England,

where tulips were traded on the London Stock Exchange. In both cities, traders strove to push tulip prices up to

the lofty levels seen in Amsterdam but were only moderately successful in their attempt (The Tulipomania, n.d).

Astronomically-high tulip bulb prices resulted in some equally astonishing anecdotes such as the sailor who

mistakenly ate an extremely rare SemperAugustus tulip bulb thinking it was an onion. This "onion" was so

valuable that it could have fed his whole ship's crew for an entire year. The hapless sailor was jailed for several

months for his innocent but costly mistake.Another similar anecdote is of an traveling English botanist who

was unaware of the Dutch tulip mania of the time, who peeled and dissected a wealthy Dutchman's four

thousand florin Admiral Von der Eyk tulip bulb mistaking it for an unusual species of onion. The bewildered

English traveller was quickly led through the streets, followed by a mob, to be brought before a judge who

sentenced him to prison until he could pay for the damage (The Tulipomania, n.d).

The Crash

Like all bubbles, the Dutch tulip bulb bubble continued to inflate beyond people's wildest expectations until it

abruptly "popped" in the winter of 1636-37.Adefault on a tulip bulb contract by a buyer in Haarlem was the

main bubble-popping catalyst and caused the tulip bulb market to violently implode as sellers overwhelmed the

market and buyers virtually disappeared altogether. Some traders attemped to support prices, to no avail.

Within just a few days, tulip bulbs were worth only a hundredth of their former prices, resulting in a f ull-blown

panic throughout Holland. Dealers refused to honor contracts, further damaging confidence in the tulip bulb

market. Eventually, the government attempted to stem the the tulip market meltdown by offering to honor

contracts at 10% of their face value, which only caused the market to plunge even further. The brutal popping

of the tulip bulb bubble ended the Dutch Golden Age and hurled the country into a mild economic depression

that lasted for several years. The traumatic tulip bulb crash resulted in a suspicion toward speculative

investments in Dutch culture for a very long time after. (One also has to wonder if this is how the Dutch

reputation for frugality arose!)

Related Web Resources:

Wikipedia: Tulip Mania

Market Crashes: The Tulip and Bulb Craze

The Dutch Tulip Bubble of 1637

When the Tulip Bubble Burst

The Tulipomania:An Investing Bubb4e

References:

Allan Bellows. (2012). The Dutch Tulip Bubble of 1637. Retrieved 15th April 2012, from

http://www.damninteresting.com/the-dutch-tulip-bubble-af-16371

Investopedia.(2012). The Greatest Market Crashes. Retrieved on 17th April, 2012, from

http://www.investapedia.com/features/crashes/crashes2.asp

The Tulipomania. (n.d.). Tulipmania and Investing. Retrieved on 16th April, from, http:/lwww.thetulipomania.com/

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UNDERSTANDING TH E US TREASURY YIELD CURVE

by Robert F. DeLucia, CFA Consulting Economist

Summary and Major Conclusions:

■ The US Treasury yield curve is a snapshot of market yields on government bonds extending across t~~t~ifc~statiot? of t1~~ the maturity spectrum. Also referred to as the term structure of interest rates, the yield curve can

ti~r~~st of Fer/Pra1 f;~~erv~~ assume three shapes: Upward sloping, downward sloping, and flat.

,C~oliCy ire c'C7/Ifl;t~c'tio~~ The Treasury yield curve tends to be upward sloping over very long periods of time, simply because

i nvestors need to be compensated with additional returns to be willing to invest in longer-maturity ~vitl; rrnderlyiny bonds. Similarly, borrowers are willing to pay a slightly higher interest rate for the benefit of locking

e~c~tJ~trri~~ ~:~~rre~rfiurts. in borrowing costs over a longer timeframe.

T/re curve rs an Movements in long-term interest rates can be best explained by major shifts in monetary policy.

extrett~~Jy valt.~~bJP The correlation coefficient between long-term bond yields and changes in the federal funds rate is

nearly 0.80. Other fundamental drivers of bond market trends —GDP growth, inflation, federal

aria/ytrcal toc:~( for budget de ficits —have far less predictive power with respect to the direction of long-term bond

yields. in vr:~stors, ceannrrrists,

~nd~o/iry~r~akers. /n In a fundamental textbook context, the level of long-term bond yields is roughly equivalent to the

arithmetic average rate of the overnight federal funds rate over the term of the longer-dated bond,

~articu/ar, thc~~ sir~pe v~ plus a moderate term premium. A shift in market expectations regarding the future thrust of

monetary policy is immediately reflected in market yields on long-term bonds.

the yrE~Jd curve,~rovides

valuable iriforrr~alian The yield curve is an extremely valuable analytical tool for investors, economists, and policymakers.

I n particular, the shape of the curve provides valuable information regarding the current conduct of

regarding t/ae curr~Trlt monetary policy, the current stage of the business cycle, and the future trend in long-term interest

rates. candur:t of rrronetary

,UoliGy, the current stage ■ I believe that the strong consensus view that the yield curve is in a persistent flattening pattern will

prove to be incorrect. More likely, an interim counter-trend steepening of the curve will be triggered

of t/~e busitl~s.5 cyc/r:~, by upside surprises with respect to econom ic growth, inflation, and the future pace of the FOMC's

rate-tightening cycle. end tite expecte:~ fc~tt~r~e

trend' iir lory,~;-(~;~rrr~ The magnitude and duration of an interim yield curve steepening will depend upon the FOMC's

response to evidence of an improving economy. The curve will continue to steepen until investors

inthrE~:;t rtes, A become convinced that monetary policy is no longer excessi vely easy. Conversely, the curve will

begin to fatten once the Federal Reserve responds aggressively to the prospect of faster growth and ste~,r~~nir7g,yie~~' c~urv~ rising inflation.

wc~u/c~' b~~ a ~;~vsitivc:~ A sustained cyclical flattening in the yield curve appears likely once the FOMC shifts to a more

siona/ for ecvr7nrnic.~a/!y aggressive rate-tightening policy during 2017, and as investors begin t o anticipate an end to the

current business expansion cycle. This final-stage flattening trend could commence in 2017 and serlsi~iv~ assets, such ~s persist well into 2018.

co~r~ir;on stoc~s, ht~f ~a The implications for investors are clear: A steepening yield curve is a positive signal for

r,~r~g~?tivr~ ,s~r~;Y~l~/ ~,~r (nrr~7.. economically sensitive assets such as common stocks, but a negative signal for long-term

government bonds. The equity market will ultimately become vulnerable once the subsequent curve Tt~rrrr,.;~v~:~r~~r!;%~~r~ t;1~;7^s, flattening trend enters an advanced phase.

~YXIJi LPL ~~Z~I~I:I~~~Z~7

There has been considerable discussion regarding the outlook for the yield curve

and its implications for the domestic economy and financial markets. This week's

Economic Perspective provides an in-depth analysis of the internal dynamics of

the yield curve along with key implications for the economy and financial

markets.

THE TERM STRUCTURE OF INTEREST RATES

The yield curve is a l inear graph that depicts the variation in market interest

rates for different maturities at a single point in time. Also referred to as the term

structure of interest rates, the yield curve is a snapshot of market yields on bonds

of identical credit quality across the maturity spectrum. At the present time, an

abbreviated yield curve of US Treasury securities consists of the followingvields:

0.30% (3-month bi l ls); 0.55% (1-year bi l ls); 0.81% (2-year notes); 1.25%

(5-year notes); 1.55% (7-year notes); 1.75% (10-year notes); and 2.50% for

30-year bonds (see chart 1).

Upwardly Sloped Curve: As a broad generalization, the yield curve at any point in

time can assume three positions: U,awards/oping(positivelysloped); downward

s/oPing(negatively sloped or inverted); and f/at. For the vast majority of time, the

yield curve is in an upward sloping (positive slope) position —with long-term

rates higher than short-term rates.

■ Term Premium: The explanation for this reality is simple: /nvestors insist

on bein compensated for the added risk associated with t~~p their

money for a /or~ger timeframe. The spread between a higher yielding long-

term bond and glower-yielding short-term bond is referred to as the term

premium. In a similar way, borrowers are wil l ing to pay a slightly higher

i nterest rate in order to lock in borrowing costs over a longer timeframe.

As an example, the term premium (yield differential) between 10 year

Treasury bonds and 3-month Treasury bills has been 110 basis points

over the past 30.years.

Useful Analytical Tool: The yield curve is an extremely valuable analytical tool for

i nvestors, economists, and policvmakers. Yield differentials (spreads) between

the federal funds rate ar~d the 10-year US Treasury bond tend to be the preferred

metric for analysis; the yield differential between 2;vearand 10-year US Treasury

securities is also commonly used to analyze market conditions. Chart 3 depicts

the historical yield differential or term spread between ten-year Treasury bonds

and the federal funds rate.

Explaining the Curve: There is a systematic relationship between the slope of the

yield curve and underlying economic and financial conditions. The shade (slope)

of the yield curve at an,L,goint in time can be explained by three interrelated

factors:

0271104-00083-00 2

CHART 1 Current Yield Curve: Traditional Upward Slope US Treasury Yield Plotted on October 19, 2016 Source: Bloomberg

°~~ Z,75

2.25

1.75

CHART 2 Classic Inverted Yield Curve One Year Prior to the Great Recession in 2008 US Treasury Yield Curve Plotted on March 31, 2007 Source: Bloomberg

%5,5~

5.25 ~

5.00

March 37, 207

4,15

4.50 One Two Three Five Seven Ten Thirty Month Year Year Year Year Year Year

October 19, 2016

1.25

0.75

0,25 Three Two Three Five Seven Ten Thirty Month Year Year Year Year Year Year

➢ Market Expectations: The,vield curve is ar~ly the most reliable indicator of the expected direction of interest rates. A steep upwardly sloped curve is consistent with expectations for a rising trend in rates; conversely, a downwardly sloped (inverted) yield curve reflects market expectations of an imminent decline in market interest rates. A flat yield curve implies investor expectations of a stable (sideways) interest rate structure (see chart 2).

y The Business Cycle: As a generalization, the shape of the yield curve tends to exhibit a roughly consistent pattern over the course of the traditional business cycle. The curve tends to reach its maximum steepness during the very early years of an economic recovery (e.g., 1972, 1976, 1985, 1992, 2002, and 2010). The curve tends to flatten as the expansion matures —and becomes inverted (downward sloping1 iust prior to recessions, as occurred in 1969. 1974, 1980, 1989, 2000, and 2006. Indeed, among the various economic and financial indicators, the shape of the yield curve is the most reliable harbinger of a looming recession (see chart 3).

0271104-00083-00 3

CHART 3 Yield Curve Follows a Consistent Pattern Over a Business Cycle

Yield Spread (%) Between 10-Year US Treasury Notes and Overnight Federal Funds

Source: Bloomberg

% J.Q

4.0

3.0

2.0

1.4

-1.0 -

-2.0 , 1986 X991 1996 2009 2006 2011 2 16

➢ Monetary Policy: The yield curve reflects the thrust of Federal Reserve

policy in conjunction with underlying economic conditions. It tends to be

i n a steep upward slope during times when policy is overly

accommodative, a clear indication that the Fed is inappropriately

expansionary and lagging an expanding economy. Conversely, a flat or

negatively sloped (inverted) yield curve indicates that policy is excessively

tight in the context of current business conditions —therein signaling a

period of economic weakness ahead.

Basic Fundamental Principles: In addition, there are several significant

behavioral patterns associated with the ,Leld curve that can be very useful for

i nvestors:

v Explaining Long-Term Rates: Changes in the Federal Reserve's overni~t

policy rate are the most significant driver of changes in long-term rates.

The long-term historical correlation coefficient between long-term

Treasury bonds and the federal funds rate is nearly 0.80, which means

that changes in the federal funds rate explain 80% of the corresponding

movement in long-term rates. Other fundamental factors such as

i nflation, government deficits, and GDP growth are certainly relevant, but

of secondary importance.

0271104-00083-00 4

y Correlations: As a general rule, market yields on bonds of different

maturities tend to move in the same direction although not by the

same amount —with changes in short-term rates typically exceeding

changes in long-term rates.

v Yield Relationships: It is crucial to understand that the market, ie/d on

loner term rates is an average of the expected future path of short-term

rates over the maturity of the /on~er-term bond. As an example, the

current market yield of 1.75% on 10-year US Treasury bonds is the

approximate average of investor expectations for the future path of the

overnight federal funds rate currently at 0.50% —over the next ten-

year duration of the Treasury bond.

• There are two implications of this basic principle: (1) Investors

expect the yield on the overnight federal funds rate to average

1.75% over the next ten years; and (2) By definition, a current federal funds rate of 0.50% along with an implied ten-year

average of 1.75% means that investors expect the Fed's main

policy rate to rise above the current 1.75% bond yield in future years.

Credit Availability: The shape of the yield curve is also a reliable leading

i ndicator of economic growth because of its powerful influence on

incentives for bank /ending Because banks and nonbank financial

i nstitutions (insurance companies) tend to lend lon~and borrow short,

lending in a steep upwardly sloped yield curve environment is most

profitable for banks — as net interest margins are maximized. Conversely,

a flat yield curve implies tight lending spreads (downward pressure on net

i nterest income) and therefore reduced incentives for banks to extend

credit.

CURRENT MARKET CONDITIONS

The shape of the yield curve has been somewhat volatile in recent years —

especially in comparison with the 1980s and 1990s —resulting in considerable

confusion among fixed-income investors. Recent trends with respect to the US

Treasur ~r vield curve can be summarized as follows:

➢ A consistently flattening trend since 2014, which has gathered

momentum beginning in 2015. Using the spread between 10-year

Treasury bonds and one-year US Treasury bi l ls, the yield curve has

flattened from 290 basis points (bps) in early 2014 to only 100 bps

currently.

0271104-00083-00 5

CHART 4 Federal Reserve's Policy Rate Held Near Zero For an Unprecedented Seven Years

The Overnight Federal Funds Target %Rate (Upper Bound)

Source: Bloomberg

ado ~

4 '

Q rn-r. r.,..r_i..;..~..._r~--..~.~,..,._~..,..,..,..~...,:.T._.~_~_.;.ry..~.~.._rrrr--r~~T1r-r-rr~~r-~~r: i rrt,._~_~~r..,...r,._~.,..Trn::T..i..r..r..~..;

1996 2Q00 2004 2008 2Q12 2416

➢ Since 2015, the yield differential between short- and long-term rates has

narrowed to a level be%w the average of the past 50 years. Using the

yield differential between 10-year Treasury bonds and the overnight

federal funds rate, the current spread of 125 bps is below the long-term

average of 160 bps, although wel l above the all-time low of -125 basis

points.

Unique Credit Cycle: It is important to understand the unusual behavior of the

curve over the past six years. The traditional yield curve has behaved in a unique

even unprecedented manner during the current credit cycle:

1. Zero Policy Rates: The Federal Reserve has held its overnight policy rate

near zero for an unprecedented seven years (see chart 4).

2. Quantitative Easing: Through its massive purchases of long-term

government bonds, the Federal Reserve has (deliberately) exerted

relentless downward pressure on long-dated fixed-income securities in

order to minimize borrowing costs for consumers, homebuyers, and

businesses.

0271104-00083-00 6

4. Foreign Market Yields: Negative interest rates on bonds, notes, and policy

rates in Europe and Japan have consistently influenced the shape of the

domestic yield curve since 2014.

YIELD CURVE OUTLOOK

The consensus view among investors is that the yield curve is in a sustained

cyclical flattening trend that wi l l persist unti l the next recession. I disagree, and

believe that the next change in the yield curve wi l l involve a temporary but

substantive counter-trend steepening that could persist for several months, at a

minimum . The catalyst for such a shift would be a sudden change in market

expectations regarding the outlook for economic growth, inflation, and the thrust

of monetarypolicy.

Yield Curve Message: The current shape of the Treasury yield curve reflects the

consensus market view of persistently sluggish growth; continued low levels of

wage and price inflation; and the l ikelihood of only minimal increases in policy

rates for the foreseeable future. Conversely, my forecast assumes upside

surprises over the next year with respect to the rate of US economic growth, wage

and price inflation, and the pace of the Federal Reserve's rate-tightening cycle.

■ Temporarily Steepening: If my forecast is correct, the yield curve should

gradually shift to a steeper upward slope during the next six months —

long-term rates would rise at a faster pace relative to short- and i ntermediate-term rates — as investors discount a higher level of policy

rates in future years.

■ Market Expectations: The key to this assumption is the expectations principle, which postulates that the current market,~ie/d on %n~ term

rates is the average of exaected central bank ,nolicv rates exaected over

the maturity of the loner-term bond. In short, rising expectations

regarding the FOMC's rate-tightening cycle should reverberate out along

the overal l yield curve, pushing long-term rates higher.

■ Federal Reserve Response: The duration of this anticipated steepening

chase is predicated upon the interaction of monetary Qolicv and the economy If the FOMC drags its feet in an environment of more rapid

economic growth and spreading inflationary pressures —thereby fal l ing

further behind the economic curve —the steepening trend wi l l persist.

Conversely, if the FOMC votes to tighten monetary conditions aggressively, the yield curve would begin to flatten, in anticipation of

slower economic growth and fal l ing rates.

0271104-00083-00 7

3. Yield Curve Catalyst: Historically, shifts in the yield curve have been precipitated primarily by changes in short-term rates. Since the financial

crisis, shifts in the curve have been mainl~tri~,~ered by changes in loner

term rates.

■ Classic Cyclical Pattern: Beyond this potential short-term market adjustment phase, the yield curve should revert to its traditional cyclical

pattern: A sustained flattening trend as investors begin to anticipate the

/ate stakes ofa business expansion cyc%. Although the precise timing is

i mpossible to predict, the yield curve should begin a gradual flattening

trend during 2017, which should persist wel l into 2018.

■ Inverted Yield Curve: The curve wi l l eventually flatten and begin to invert

(short-term rates above long-term rates) as the expansion cycle nears an

end. Throughout history, recessions have commenced rou~lvone year

fol%wind an inversion of the.vield curve, the most like/ ytimin~ of which

would be the period beyond 2018.

INVESTMENT IMPLICATIONS

The US Treasury yield curve can be a powerful tool for investors in equity and

fixed-income markets. If the curve steepens in future months as i expect, the

i mplications would be favorable for pro-growth assets, such as common stocks,

and negative for bonds. A steepening trend would be indicative of a stronger

economy and a rising trend in corporate earnings in conjunction with an

overly accommodative Federal Reserve, a combination that implies higher

i nterest rates in future months.

As previously discussed, the duration of this temporary counter-cyclical

steepening trend wi l l be a function of the FOMC's response to evidence of a

stronger economy. My assumption is that the Federal Reserve wi l l continue to err

on the side of monetary accommodation, even in the face of a strengthening

economy. This would have the effect of perpetuating a more steeply sloped

curve, delaying the inevitable flattening process consistent with the final phases

of a business expansion. In this environment, common stocks would continue to

significantly outperform fixed-income markets.

Eventually, these economic and policy trends would give way to a major shift in

asset class leadership. Government bonds wi l l begin to outperform stocks under

the following circumstances:

■ Afar more a~~ressive rate-tightenin~cvc/e whereby the Federal Reserve

is no longer behind the economic curve, and is becoming a threat to the

expansion

■ Investors begin to anticipate a sharp slowdown in the rate of economic

growth and thereby, a lower interest rate environment

■ In response, an accelerated f/attenin~of the Treasury yield curve

0271104-00083-00 8

An outright inversion of the yield curve, which has in the past consistently preceded the onset of recession by approximately one year

These classic cyclical developments will signal a looming recession and the onset

of the next cyc/ica/ bear market in stocks. They would also signal that the next

bul l market in government bonds is imminent. While impossible to be precise,

my judgment is that this late-business cycle scenario is unlikely to unfold unti l

after 2018. In the interim, common stocks should continue to outperform bonds

i n an environment of either a moderate steepening or stabi l ization of the yield

curve. if histor yi's a guide, the cyclical peak in the equity market would occur

rou~ly one ,year prior to an inversion in the Treasurv.vield curve.

Robert F. DeLucia, CFA, was formerly Senior

Economist and Portfolio Manager for Prudential

Retirement. Prior to that role, he spent 25 years at

CIGNA Investment Management, most recently serving

_ __ as Chief Economist and Senior Portfolio Manager. He

currently serves as the Consulting Economist for

Prudential Retirement. Bob has more than 40 years of

i nvestment experience.

The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as

recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding

the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned

herein, the recipients) of this report must make its own independent decisions.

Certain information contained herein may constitute "forward-looking statements," (including observations about markets and industry and regulatory

trends as of the original date of this document). Due to various risks and uncertainties, actual events or results may differ materially from those reflected or

contemplated in such forward-looking statements. As a result, you should not rely on such forward-looking statements in making any decisions. No

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0271104-00083-00 9

The Wall Street Journal

U.S. Government Bonds Pull Back Treasury yields edge higher ahead of auctions, data

Sam Goldfarb The Wall Street Journal

Updated May 8, 2017 3:36 p.m. ET

U.S. government bond prices drifted lower Monday as investors anticipated coming economic data releases and a round of bond auctions this week.

The yield on the benchmark 10-year Treasury note settled at 2.376%, above the 2.352% on Friday.

Yields, which rise when bond prices fall, have trended upward in recent weeks as alarming geopolitical headlines receded into the background and investors increasingly focused on the potential for the Federal Reserve to raise interest rates at its June policy meeting.

One element of uncertainty that had weighed on yields in recent months was removed on Sunday as the centrist Emmanuel Macron was elected president of France in an easy victory over the far-right candidate, Marine Le Pen, who had threatened to pull the country out of the eurozone.

A win for Ms. Le Pen had been feared by investors but was seen as highly unlikely by the final days of the campaign, keeping the vote from having a major impact on the market.

Despite Mr. Macron's victory, yields on safe-haven government bonds fell modestly in the European trading session, before rising when the U.S. market opened.

"At this point we're just kind of seeing some squaring up in the U.S. market" with i nvestors "looking ahead to supply this week and a couple of the data points," including reports on the consumer-price index and retail sales, said John Herrmann, director of rates strategy at MUFG Securities in New York.

This week's auctions kick off Tuesday with a $24 billion sale of three-year notes, followed by a $23 billion sale of 10-year notes Wednesday and a $15 billion sale of 30- year bonds Thursday. An influx of new bonds can sometimes outpace demand, causing prices on existing bonds to fall in the secondary market.

Though still well below the 2.6% level it reached in December and March, the 10-year yield has been on the upswing lately, rising from afive-month low of 2.177% in mid- April.

Fed officials, at a policy meeting last week, held short-term interest rates steady as widely expected, following a rate increase in March. But in a policy statement, officials said slow growth earlier this year was "likely to be transitory." On Friday, new data showed the unemployment rate falling to its lowest level in a decade, further bolstering confidence among investors that the Fed will act again in June.

When the Fed raises short-term interest rates, it tightens money supply in the economy and tends to shrink the value of outstanding bonds.

Fed funds futures, used by investors to place bets on the Fed's interest-rate policy, on Monday showed an 83% chance that the Fed will tighten policy at its June meeting, according to CME Group .That was up from 68% one week ago.

Still, the chances of at least one more interest-rate increase by the Fed's December meeting were put at just 57%, indicating many investors remain cautious about predicting rate increases over a longer time horizon.

UNDERSTANDING THE US TREASURY YIELD CURVE

by Robert F. DeLucia, CFA Consulting Economist

Summary and Major Conclusions:

Tire yield curve r4 a ■ The US Treasury yield curve is a snapshot of market yields on government bonds extending across

l77~~1ift~stat(on of tfle the maturity spectrum. Also referred to as the term structure of interest rates, the yield curve can

r'i~rust of Federal Reserve assu me three shapes: Upward sloping, downward sloping, and flat.

~volicy ire cai7,jutrc:ti~rr The Treasury yield curve tends to be upward sloping over very long periods of time, simply because i nvestors need to be compensated with additional returns to be willing to invest in longer-maturity

W%tI7 11~CJ~l,'I'~j/(17~L; bonds. Similarly, borrowers are willing to pay a slightly higher interest rate for the benefit of locking

eCunoiniC C:C~~tC~itiot7s. in borrowing costs over a longer timeframe.

7~/'1Gs curve is Sri Movements in long-term interest rates can be best explained by major shifts in monetary policy.

extreme/y valuat~le The correlation coefficient between long-term bond yields and changes in the federal funds rate is

nearly 0.80. Other fundamental drivers of bond market trends —GDP growth, inflation, federal

analytfcal toil for budget deficits —have far less predictive power with respect to the direction of long-term bond

yields. invr~s~ors, er;anr~mrsts,

and,r~nlicyrl~~kers. In ■ In a fundamental textbook context, the level of long-term bond yields is roughly equivalent to the

arithmetic average rate of the overnight federal funds rate over the term of the longer-dated bond,

partiCu/ar, t/~e sh~~e of plus a moderate term premium. A shift in market expectations regarding the future thrust of

monetary policy is immediately reflected in market yields on long-term bonds.

the,yi~ld curve pravid~~s

valuable rriforir~atrnr~ The yield curve is an extremely valuable analytical tool for investors, economists, and policymakers.

I n particular, the shape of the curve provides valuable information regarding the current conduct of

regardirr~ thEr current monetary policy, the current stage of the business cycle, and the future trend in long-term interest

rates. conduct of mor~Ptary

~.)o/iC.y, the eu~rent 4tage ~ I believe that the strong consensus view that the yield curve is in a persistent flattening pattern will

prove to be incorrect. More l ikely, an interim counter-trend steepening of the curve will be triggered

af~fhe business cycle, by upside surprises with respect to economic growth, inflation, and the future pace of the FOMC's

rate-tightening cycle. and the ~xpPr, t~r~ firtrire

tr~arlc~ rn Ivn~;-f~:~rrn The magnitude and duration of an interim yield curve steepening will depend upon the FOMC's

response to evidence of an improving economy. The curve will continue to steepen until investors

interest rates. A become convinced that monetary policy is no longer excessively easy. Conversely, the curve wi l l begin to flatten once the Federal Reserve responds aggressively to the prospect of faster growth and

steer~enirr~,yi~(d cur✓r' rising inflation.

WC7UIC~ ~1t' %~ ~")OS1tfVE' . A sustained cyclical flattening in the yield curve appears likely once the FOMC shifts to a more

signal for ~::c~r~omira!/y aggressive rate-tightening policy during 2017, and as investors begin to anticipate an end to the current business expansion cycle. This final-stage flattening trend could commence in 2017 and

sensitive assets, SUCK 4~s persist wel l into 2018.

c0~tlmon StoC,k,S, ht~t ~ The implications for investors are clear: A steepening yield curve is a positive signal for

rlegat(Ve si~'tta/ fcu' /o;:g~~ economically sensitive assets such as common stocks, but a negative signal for long-term

government bonds. The equity market will ultimately become vulnerable once the subsequent curve tet'm ~Cvs~rl?;?1t~i1iij'~-?,~s, flattening trend enters an advanced phase.

0271104-00083-00

There has been considerable discussion regarding the outlook for the yield curve

and its implications for the domestic economy and financial markets. This week's Economic Perspective provides an in-depth analysis of the internal dynamics of

the yield curve along with key implications for the economy and financial markets.

THE TERM STRUCTURE OF INTEREST RATES

The yield curve is a l inear graph that depicts the variation in market interest rates for different maturities at a single point in time. Also referred to as the term

structure of interest rates, the yield curve is a snapshot of market yields on bonds of identical credit quality across the maturity spectrum. At the present time, an

abbreviated yield curve of US Treasury securities consists of the following yields:

0.30% (3-month bills); 0.55% (1-year bi l ls); 0.81% (2-year notes); 1.25% (5-year notes); 1.55% (7-year notes); 1.75% (10-year notes); and 2.50% for

30-year bonds (see chart 1).

Upwardly Sloped Curve: As a broad generalization, the yield curve at any point in

time can assume three positions: Upwards/oiling(positively sloped); downward

s/o in (negatively sloped or inverted); and f/at. For the vast majority of time, the yield curve is in an upward sloping (positive slope) position —with long-term

rates higher than short-term rates.

■ Term Premium: The explanation for this reality is simple: /nvestors insist on bein~per~sated for the added risk associated with t~~p their money for a /on~er timeframe. The spread between a higher yielding long- term bond and glower-yielding short-term bond is referred to as the term premium. In a similar way, borrowers are wi l l ing to pay a slightly higher

i nterest rate in order to lock in borrowing costs over a longer timeframe. As an example, the term premium (yield differential) between 10-year Treasury bonds and 3-month Treasury bills has been 110 basis points over the past 30 ,years.

Useful Analytical Tool: The yield curve is an extremely valuable analytical tool for i nvestors, economists, and policymakers. Yield differentials (spreads) between

the federal funds rate and the 10 year US Treasury bond tend to be the preferred metric for analysis; the yield differential between 2,vearand IO.vear US Treasury

securities is also commonly used to analyze market conditions. Chart 3 depicts

the historical yield differential or term spread between ten-year Treasury bonds

and the federal funds rate.

Explaining the Curve: There is a systematic relationship between the slope of the yield curve and underlying economic and financial conditions. The shape (slope)

of the yield curve at an~point in time can be explained by three interrelated factors:

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CHART 1 Current Yield Curve: Traditional Upward Slope US Treasury Yield Plotted on October 19, 2016 Source: Bloomberg

°~~ 2,15

2.25

1.75

October 19, 2016

1.25

0.75

0.25 Three Two Three Five Seven Ten Thirty Month Year Year Year Year Year Year

CHART 2 Classic Inverted Yield Curve One Year Prior to the Great Recession in 2008 US Treasury Yield Curve Plotted on March 31, 2007 Source: Bloomberg

~~~5,~~

5.25

SAO

March 31, 2001

4,t5

4,~0 One Two Three Five Seven Ten Thirty Month Year Year Year Year Year Year

➢ Market Expectations: The yield curve is ar~ly the most reliable indicator of the erected direction of interest rates. A steep upwardly sloped curve is consistent with expectations for a rising trend in rates; conversely, a downwardly sloped (inverted) yield curve reflects market expectations of an imminent decline in market interest rates. A flat yield curve implies investor expectations of a stable (sideways) interest rate structure (see chart 2).

The Business Cycle: As a generalization, the shape of the yield curve tends to exhibit a roughly consistent pattern over the course of the traditional business cycle. The curve tends to reach its maximum steepness during the very early years of an economic recovery (e.g., 1972, 1976, 1985, 1992, 2002, and 2010). The curve tends to flatten as the expansion matures —and becomes inverted (downward sloping) iust ,prior to recessions, as occurred in 1969, 19.74 1980, 1989, 2000, and 2006. Indeed, among the various economic and financial indicators, the shape of the yield curve is the most reliable harbinger of a looming recession (see chart 3).

0271104-00083-00 3

CHART 3 Yield Curve Follows a Consistent Pattern Over a Business Cycle Yield Spread (%) Between 10-Year US Treasury Notes and Overnight Federal Funds Source: Bloomberg

°10 5.0

4.0

3.0

2.0

1.0

a.o - ---- -,- ,

-~.o

-Z.o 1986 1991 1996 2Q01 2006 ~Q11 Z~16

Monetary Policy: The yield curve reflects the thrust of Federal Reserve policy in conjunction with underlying economic conditions. It tends to be i n a steep upward slope during times when policy is overly accommodative, a clear indication that the Fed is inappropriately expansionary and lagging an expanding economy. Conversely, a flat or negatively sloped (inverted) yield curve indicates that policy is excessively tight in the context of current business conditions —therein signaling a period of economic weakness ahead.

Basic Fundamental Principles: In addition, there are several significant behavioral patterns associated with the yield curve that can be very useful for i nvestors:

0271104-00083-00

v Explaining Long-Term Rates: Changes in the Federal Reserve's overni~t policy rate are the most significant driver of char~~es in lon,~ term rates. The long-term historical correlation coefficient between long-term Treasury bonds and the federal funds rate is nearly 0.80, which means that changes in the federal funds rate explain 80% of the corresponding movement in long-term rates. Other fundamental factors such as i nflation, government deficits, and GDP growth are certainly relevant, but of secondary importance.

y Correlations: As a general rule, market yields on bonds of different maturities tend to move in the same direction although not by the

same amount —with changes in short-term rates typically exceeding

changes in long-term rates.

v Yield Relationships: It is crucial to understand that the market vie/d on

long-term rates is an average of the expected future path of short-term

rates over the maturity of the longer-term bond. As an example, the

current market yield of 1.75% on 10-year US Treasury bonds is the

approximate average of investor expectations for the future path of the

overnight federal funds rate —currently at 0.50% —over the next ten-

year duration of the Treasury bond.

• There are two implications of this basic principle: (1) Investors

expect the yield on the overnight federal funds rate to average

1.75% over the next ten years; and (2) By definition, a current

federal funds rate of 0.50% along with an implied ten-year

average of 1.75% means that investors expect the Fed's main

policy rate to rise above the current 1.75% bond yield in future

years.

~ Credit Availability: The shape of the yield curve is also a reliable leading

i ndicator of economic growth because of its powerful influence on

incentives for bank /ending: Because banks and nonbank financial

i nstitutions (insurance companies) tend to lend lon~and borrow short,

lending in a steep upwardly sloped yield curve environment is most profitable for banks — as net interest margins are maximized. Conversely,

a flat yield curve implies tight lending spreads (downward pressure on net

i nterest income) and therefore reduced incentives for banks to extend

credit.

CURRENT MARKET CONDITIONS

The shape of the yield curve has been somewhat volatile in recent years —

especially in comparison with the 1980s and 1990s —resulting in considerable

confusion among fixed-income investors. Recent trends with respect to the US

Treasur~vield curve can be summarized as follows:

A consistently flattening trend since 2014, which has gathered momentum beginning in 2015. Using the spread between 10-year Treasury bonds and one-year US Treasury bi l ls, the yield curve has

flattened from 290 basis points (bps) in early 2014 to only 100 bps currently.

0271104-00083-00 5

CHART 4 Federal Reserve's Policy Rate Held Near Zero For an Unprecedented Seven Years The Overnight Federal Funds Target %Rate (Upper Bound) Source: Bloomberg

3 ' i i

2 l

Q ~ . _... i..i..i..i.,..i..~.r.r.i..i.....i..,_~..,..~_~..~..., i ~...._i. _.;.~.... ..' __ ~ i T_ .~........~-.i-s..~.....~..~ i i..T......__i_...__~.~~...7..fTTT71Tf-T-f-'fl'TT i7 i iTtT':. 1996 2QQ0 24Q4 2008 2012 2016

➢ Since 2015, the yield differential between short- and long-term rates has narrowed to a level be%w the average of the past 50,vears. Using the yield differential between 10-year Treasury bonds and the overnight federal funds rate, the current spread of 125 bps is below the long-term average of 160 bps, although wel l above the all-time low of -125 basis points.

Unique Credit Cycle: It is important to understand the unusual behavior of the curve over the past six years. The traditional yield curve has behaved in a unique — even unprecedented —manner during the current credit cycle:

1. Zero Policy Rates: The Federal Reserve has held its overnight policy rate near zero for an unprecedented seven years (see chart 4).

2. Quantitative Easing: Through its massive purchases of long-term government bonds, the Federal Reserve has (deliberately) exerted relentless downward pressure on long-dated fixed-income securities in order to minimize borrowing costs for consumers, homebuyers, and businesses.

0271104-00083-00 6

4. Foreign Market Yields: Negative interest rates on bonds, notes, and policy

rates in Europe and Japan have consistently influenced the shape of the

domestic yield curve since 2014.

YIELD CURVE OUTLOOK

The consensus view among investors is that the yield curve is in a sustained

cyclical flattening trend that wi l l persist unti l the next recession. I disagree, and

believe that the next change in the yield curve wi l l involve a temporary but

substantive counter-trend steepening that could persist for several months, at a

minimum . The catalyst for such a shift would be a sudden change in market

expectations regarding the outlook for economic growth, inflation. and the thrust

of monetary pollCy.

Yield Curve Message: The current shape of the Treasury yield curve reflects the

consensus market view of persistently sluggish growth; continued low levels of

wage and price inflation; and the likelihood of only minimal increases in policy

rates for the foreseeable future. Conversely, my forecast assumes upside

surprises over the next year with respect to the rate of US economic growth, wage

and price inflation, and the pace of the Federal Reserve's rate-tightening cycle.

■ Temporarily Steepening: If my forecast is correct, the yield curve should gradually shift to a steeper upward slope during the next six months — long-term rates would rise at a faster pace relative to short- and

i ntermediate-term rates — as investors discount a higher level of policy

rates in future years.

■ Market Expectations: The key to this assumption is the expectations

principle, which postulates that the current market yie/d on %n~ term

rates is the average of expected central bank policy rates exoected over

the maturity of the loner-term bond. In short, rising expectations

regarding the FOMC's rate-tightening cycle should reverberate out along

the overal l yield curve, pushing long-term rates higher.

■ Federal Reserve Response: The duration of this anticipated steepenin

phase is ,predicated u,non the interaction of monetary ,nolicv and the

0271104-00083-00

economy If the FOMC drags its feet in an environment of more rapid

economic growth and spreading inflationary pressures —thereby fal l ing

further behind the economic curve —the steepening trend wil l persist.

Conversely, if the FOMC votes to tighten monetary conditions aggressively, the yield curve would begin to flatten, in anticipation of

slower economic growth and fal l ing rates.

3. Yield Curve Catalyst: Historically, shifts in the yield curve have been precipitated primarily by changes in short-term rates. Since the financial

crisis, shifts in the curve have been mainl~trig~ered b y changes in loner

term rates.

■ Classic Cyclical Pattern: Beyond this potential short-term market adjustment phase, the yield curve should revert to its traditional cyclical pattern: A sustained flattening trend as investors begin to anticipate the /ate stakes of a business expansion cyc%. Although the precise timing is i mpossible to predict, the yield curve should begin a gradual flattening trend during 2017, which should persist wel l into 2018.

■ Inverted Yield Curve: The curve wi l l eventually flatten and begin to invert (short-term rates above long-term rates) as the expansion cycle nears an end. Throughout history, recessions have commenced rou~ly one year fol%wing an inversion of the yield curve, the most likely timing of which would be the period beyond 2018.

I NVESTMENT IMPLICATIONS

The US Treasury yield curve can be a powerful tool for investors in equity and fixed-income markets. If the curve steepens in future months as I expect, the i mplications would be favorable for pro-growth assets, such as common stocks, and negative for bonds. A steepening trend would be indicative of a stronger economy — and a rising trend in corporate earnings in conjunction with an

overly accommodative Federal Reserve, a combination that implies higher i nterest rates in future months.

As previously discussed, the duration of this temporary counter-cyclical steepening trend wi l l be a function of the FOMC's response to evidence of a stronger economy. My assumption is that the Federal Reserve wil l continue to err

on the side of monetary accommodation, even in the face of a strengthening economy. This would have the effect of perpetuating a more steeply sloped curve, delaying the inevitable flattening process consistent with the final phases of a business expansion. In this environment, common stocks would continue to significantly outperform fixed-income markets.

Eventually, these economic and policy trends would give way to a major shift in

asset class leadership. Government bonds wi l l begin to outperform stocks under

the following circumstances:

■ Afar more aggressive rate-ti htenin~c~/e whereby the Federal Reserve is no longer behind the economic curve, and is becoming a threat to the expansion

■ Investors begin to anticipate a sharp slowdown in the rate of economic growth and thereby, a lower interest rate environment

■ In response, an accelerated f/attenin~of the Treasury yield curve

0271104-00083-00 8

■ An outright inversion of the yield curve, which has in the past

consistently preceded the onset of recession by approximately one year

These classic cyclical developments will signal a loomir~~ recession and the onset

of the next cvc/ica/ bear market in stocks. They would also signal that the next

bul l market in government bonds is imminent. While impossible to be precise,

my judgment is that this late-business cycle scenario is unlikely to unfold unti l

after 2018. In the interim, common stocks should continue to outperform bonds

i n an environment of either a moderate steepening or stabi l ization of the yield

curve. if history is a guide, the cyclical peak in the equity market would occur

roughly one .year prior to an inversion in the Treasur,~,vield curve.

Robert F. DeLucia, CFA, was formerly Senior

Economist and Portfolio Manager for Prudential

Retirement. Prior to that role, he spent 25 years at

CIGNA Investment Management, most recently serving

as Chief Economist and Senior Portfolio Manager. He