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Why did one-year notes pay more than 10-year notes during the 1980's crisis? During the early 1980's, one-year T notes paid more than the 10-year T note, which implies that nobody wanted to buy the short-term bonds. Instead, they wanted to fix their money in long-term bonds. Why is this the case?

Year    1-year Note   10-year note
1977       6.080         7.42
1978       8.340         8.41
1979       10.65         9.43
1980       12.00         11.43
1981       14.80         13.92
1982       12.27         13.01
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This directly relates to the ideas behind the yield curve. For a detailed explanation of the yield curve, see the linked answer that Joe and I wrote; in short, the yield curve is a plot of the yield on Treasury securities against their maturities. If short-term Treasuries are paying higher yields than long-term debt, the yield curve has a negative slope. There are a lot of factors that could cause the yield curve to become negatively sloped, or at least less steep, but in this case, oil prices and the effective federal funds rate may have played a significant role. I'll quote from the section of the linked answer that describes the effect of oil prices first:

a rise in oil prices may increase expectations of short-term inflation, so investors demand higher interest rates on short-term debt. Because long-term inflation expectations are governed more by fundamental macroeconomic factors than short-term swings in commodity prices, long-term expectations may not rise nearly as much as short term expectations, which leads to a yield curve that is becoming less steep or even negatively sloped.

As the graph shows, oil prices increased dramatically, so this increase may have increased expectations of short-term inflation expectations substantially.

oil prices

The other answer describes an easing of monetary policy, e.g. a decrease in the effective federal funds rate (FFR), as a factor that could increase the slope of the yield curve. However, a tightening of monetary policy, e.g. an increase in the FFR, could decrease the slope of the yield curve because a higher FFR leads investors to demand a higher rate of return on shorter-term securities. Longer-term Treasuries aren't as affected by short-term monetary policy, so when short-term yields increase more than long-term yields, the yield curve becomes less steep and/or negatively sloped.

The second graph shows the effective federal funds rate for the period in question, and once again, the increase is significant.

effective federal funds rate

Finally, look at a graph of inflation for the relevant period.

inflation

Intuitively, the steady increase in inflation from 1975 onward may have increased investors expectations of short-term inflation, therefore increasing short-term yields more than long-term yields (as described above and in the other answer).

These reasons aren't set in stone, and just looking at graphs isn't a substitute for an actual analysis of the data, but logically, it seems plausible that the positive shock to oil prices, increases in the effective federal funds rate, and increases in inflation and expectations of inflation contributed at least partially to the inversion of the yield curve. Keep in mind that these factors are all interconnected as well, so the situation is certainly more complex.


If you approve of this answer, be sure to vote up the other answer about the yield curve too.

  • 1
    +1 thanks for the referral. And again thanks for the edit there, you turned my mediocre answer into a great one. – JoeTaxpayer May 21 '13 at 17:04
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    Another situation that can lead to a similar result is severe deflation. This can lead to an environment where future cash flows are increasing in value, rather than decreasing. Usually you'd rather have money now rather than later, but in this case the purchasing power of a given amount of money would increase due to deflation rather than decrease due to inflation over time. However, this is a very uncommon scenario and not the driver of the 80's inversion. – JAGAnalyst May 23 '13 at 7:42
  • "so they undergo a "flight to quality" and invest in government debt to protect their principals. This drives up the price of long-term debt and therefore drives down interest rates". My analysis shows this not to be true. When the yield curve inverts investors are fleeing short term government debt driving up yields on short term debt that briefly pass the yields on long term debt. The long term yields don't change near as much as short term yields during these times. See the analysis in my answer. – Muro Sep 7 '13 at 12:09
  • @Muro I significantly expanded the other answer on the yield curve, as well as this one. I provided some basic analysis (well, it's not really economic analysis, it's just graphs) about oil prices and the federal funds rate, which may have contributed to the inversion of the yield curve. The other answer now contains quite a bit of information on the economic theory behind the yield curve too; it's no substitute for actual data analysis, but as a foundation it should be good enough for now. – John Bensin Sep 8 '13 at 17:09
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The 1-yr bond has a higher interest rate, but it's only guaranteed for a year. This means it is subject to reinvestment risk.

Suppose you're investing in 1981. Which sounds better?

  • 13.9% in 1981, 13.9% in 1982, 13.9% in 1983 .... until 1990
  • 14.8% in 1981, 12.3% in 1982, and even less every year after that until 1990

I've not looked up the precise interest rates but I'm guessing the former option leaves you with more money in 1991. It should be no surprise that investors were willing to pay more for it++, even if they couldn't have been totally sure in advance. :)

(++ Remember, a bond is like a coupon for a certain percentage off of future-money. If the coupon offers you fewer percent off, you're paying more present-money for each dollar of future-money you buy.)

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Your question asked about a specific time the yield curve flattened or inverted. There are other times when the yield curve inverted or flattened. You also imply in your question that investors were flocking to long term bonds which lowered their yields. I don't believe this is the case. I believe investors were fleeing from short term bonds causing the yields on short term bonds to rise to meet those of long term bonds.

The chart below shows the history of yields on US bonds over time. The shaded areas are where the yield curve flattened or inverted. Notice that after 1982 it is the short term yields that rise sharply to meet or cross the yields on longer term bonds. The yields on longer term bonds move little compared to the movement in yields on the short term bonds.

enter image description here

Thus it is investors moving out of short term bonds that cause the yield curve to flatten or invert. These investors are not moving into longer term bonds since the yields on the longer term bonds do not move much at all at these times. In fact, in 2006 the longer term bond market was only 25% of the total US public debt while short term bonds made up 75%. It would take less money to move the yields on longer term bonds than it would on short term bonds yet the longer term yields did not move near as much as short term yields.

enter image description here

So why are investors or banks moving out of short term bonds causing their yields to rise? I believe this happens for one of two reasons: they are moving into higher yielding investments or they need to raise cash to cover bad investments. Charts and more information here.

  • You state that "they are moving into higher yielding investments or they need to raise cash to cover bad investments." But why are they doing this? Theory would suggest that oil prices, rising inflation, the FFR, etc. played at least some role in the crisis the OP is referring to, but I don't see any mention of those or other factors in the answer. Maybe it's in the link you posted; can you summarize it? I haven't looked at it, but it's usually better to summarize a link in case it ever goes dead. – John Bensin Sep 8 '13 at 17:05
  • They are moving into higher yielding investments because they exist. When the housing market was booming there were many mortgage security products that seemed to be a sure thing that had higher yields than treasuries. That is, until they were not a sure thing anymore. – Muro Sep 9 '13 at 2:15
  • Right, but why not move into those higher yield investments earlier, if they were there? That's what tells me that something, e.g. economic fundamentals, commodity prices, etc. is changing either their risk preferences, expectations, the yields of higher yield investments, etc. – John Bensin Sep 9 '13 at 2:30
  • Because they weren't there earlier. More securitized mortgage products appeared as the housing boom developed. They weren't always there. Also, my other reason for leaving short term treasuries is a demand for cash. This could also be the reason as some investments go sour and there is a need to raise cash to cover margins. See Lehman. I'm not sure which it is but I think it is one of these two reasons. – Muro Sep 9 '13 at 11:22
  • Are we talking about the same crisis here? I'm referring to the OP's question about the inversion of the yield curve during the 1980's crisis, not the most recent housing/financial crisis. Your answer seems to be focused on the housing crisis, not the OP's question. – John Bensin Sep 9 '13 at 11:35

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