Why did one-year notes pay more than 10-year notes during the 1980's crisis?

Question

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

Answer 1

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.

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.

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

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.

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

Answer 2

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.)

Answer 3

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.

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.

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.