The volume has spoken, until now, of "the" rate, as though time had a single price. This plate corrects the fiction. There is not one rate but a whole curve of them — a price of time for every horizon, from the loan of a single night to the bond that comes due in thirty years. The term structure, the economists call it; the yield curve, the traders; and its shape, rising or flat or inverted, is among the most closely watched objects in all of finance. This plate will show why the price of time is a curve and not a point; what the curve's shape reveals, for it is at once a forecast, the market's collective guess at the rates to come, and a price, the premium demanded for locking money away across the years; why its inversion has the uncanny power to foretell recessions; and how the volume's question, carried into the term structure, settles upon the term premium — the extra yield of the long bond — and asks whether it is the earned wage of risk-bearing or one more administered number the central bank can bend.
Begin with the fact. Go to the market for government bonds — the safest of borrowers, whose rates are the purest prices of time, unclouded by any risk of default — and you find not one rate but a schedule of them, one for each length of loan. The overnight rate, at which banks lend one another money until morning; the three-month rate, the two-year, the ten-year, the thirty-year. Plot these against their maturities, and you trace a line: the yield curve, the price of time stretched across the horizons. Most often the line slopes upward — it costs more, per year, to borrow for ten years than for one, and the long bond yields more than the short. Sometimes it lies flat, the rates of all maturities nearly level. And sometimes, rarely and ominously, it inverts, the long rates sinking below the short, so that one is paid less, per year, to lend for a decade than for a season. The shape of the curve is the first thing the bond market looks to each morning; for it is no dead schedule of prices but a living document, dense with meaning — a forecast and a price at once.
What does the curve's shape mean? The first and deepest answer is that the curve is a forecast — that a long rate is, at bottom, the market's expectation of the short rates to come. Consider a man with money to place for two years. He may buy a two-year bond, or buy a one-year bond and, when it matures, buy another. If he is to be indifferent between the two courses — as competition, roughly, requires — then the two-year rate must equal the average of this year's one-year rate and the one-year rate he expects a year hence. And so for every maturity: the ten-year rate is, on this account, the average of the one-year rates the market expects across the coming decade. The long rate is built of expected short rates; the yield curve is the market's forecast of the future path of the rate, laid out as a line. An upward slope means the market expects short rates to rise, as the economy strengthens or inflation looms; a flat curve, that it expects them to hold; an inverted curve, that it expects them to fall. The curve is thus a window into the collective mind of the bond market — its aggregated guess, weighted by real money staked, at what the price of time will be.
The long rate is built of expected short rates; the yield curve is the market's forecast of the future, laid out as a line.
And from this forecasting power comes the curve's most famous and most uncanny property: that its inversion foretells recessions. For if an inverted curve means the market expects short rates to fall, ask why the market would expect that. Short rates fall, chiefly, when the central bank cuts them; and the central bank cuts them, chiefly, to fight a downturn. So an inverted curve is the bond market's collective forecast of a coming recession — its expectation that the bank will soon be cutting rates to rescue a faltering economy. And the forecast has proved astonishingly good: in the modern history of the American economy, almost every recession has been heralded, a year or so in advance, by an inversion of the yield curve, the long rate dipping below the short. The curve is an oracle — perhaps the single most reliable leading indicator the economy affords, trusted by many beyond any forecaster of flesh. It is not infallible: it has given the odd false signal, the central bank's own vast bond purchases can distort it, and each inversion brings its chorus insisting that this time the omen will fail. But its record is the envy of economics, and for a plain reason — it is not one forecaster's opinion but the distilled expectation of every participant in the deepest market in the world, each staking real money on the future of the rate. The price of time, stretched across the years, turns out to be a prophecy.
But the curve is not forecast alone, and the part that is not forecast is the volume's proper concern. For the expectations account, in its pure form, is not quite true: long rates run, on average, higher than the bare average of expected short rates would warrant, and the excess is the term premium — the extra yield the long bond must offer to find a buyer. Why must it? Because the long bond is riskier. Lock your money into a thirty-year bond, and you bear the risk that rates will rise before it matures — and when rates rise the price of an existing bond falls, the more steeply the longer its term, so that the long-bond holder may take a heavy loss if forced to sell before the end. He bears, too, the risk that inflation will gnaw his fixed return across the long years, and the plain inconvenience of having his money tied up and unspendable. For all these he demands compensation, and the term premium is it: the price of bearing the hazards of the long commitment. The yield curve thus slopes up for two reasons braided together — because the market expects rates to rise, and because the long bond carries a premium for its risk — and to read the curve rightly one must somehow tease the forecast apart from the premium, a notoriously difficult task. The term premium is the volume's own quarry here, for it is a single species of a larger genus, the price of risk, that a later volume must take up under its own name.
And here the volume's recurring theme returns: that the price of time, even stretched across the years, has a sovereign who can bend it. For the central bank, which sets the short rate directly, reaches the long rates too, by two means. The first is expectation: since the long rate is built of expected short rates, the bank can move the long rate by changing what the market expects it to do — by forward guidance, promising to hold the short rate low for years, and so drawing the whole curve down. The second is more direct: the bank may buy long bonds outright, in the vast operation called quantitative easing, bidding their prices up and their yields down, deliberately compressing the term premium to cheapen long borrowing when the short rate has already fallen as far as it can. By these means the curve that looks like the free forecast of a free market is, in part, the shaped product of policy — its slope flattened by guidance, its premium squeezed by purchase. The forecast embedded in it may be partly the bank's own promise read back to itself; the premium within it may be partly the bank's own buying. The oracle, it turns out, can be coached. This does not make the curve a fiction, for the market's genuine expectations and the genuine price of risk remain the larger part of it; but it means the term structure, like the level of the rate before it, is a place where the impersonal market and the deliberate hand of authority are mixed past easy parting.
The forecast may be partly the bank's own promise read back to itself; the premium partly the bank's own buying. The oracle, it turns out, can be coached.
What, then, does the term structure say to the volume's question? It divides the price of time into two things, and the volume's question falls on only one of them. The first is the forecast — the expected path of short rates embedded in the curve — and a forecast is neither earned nor extracted but only accurate or mistaken; it is information, the market's collective reading of the future, and its justice is not in question, only its truth. The second is the term premium — the extra yield of the long bond — and here the volume's question bites, for the premium is a price, paid by borrowers and received by lenders, and one may ask whether it is earned. The answer is the volume's familiar both. It is earned insofar as it compensates a genuine risk: the long-bond holder truly bears the danger that rates will rise and his bond fall, that inflation will eat his return, that his money will be locked away when he wants it — and to be paid for bearing real risk is as honest as to be paid for any other real service, the matter, indeed, of the whole next volume. But it shades toward the administered, and away from the cleanly earned, insofar as the central bank compresses or inflates it at will, and insofar as captive buyers — the pension funds and insurers whom regulation compels to hold long bonds — distort it from the price that free risk-bearing would set. The term premium is the wage of patience and risk, honestly owed; but it is a wage the sovereign can dock or swell, and so it carries, like every price of time in this volume, the double character of a real reward and an administered number. The forecast in the curve may be true or false; the premium in the curve may be earned or bent; and that single rising line holds both the market's honest knowledge of the future and the price — part earned, part managed — of waiting through it.
So the volume's second half opens by dissolving its first half's central noun. There is no such thing as "the" rate; there is a curve of rates, a price of time for every horizon, and its shape carries more meaning than any single rate could. The curve is a forecast — the bond market's distilled expectation of the rates to come, the most trusted prophecy in economics, whose inversion has foretold recession after recession. And the curve is a price — the term premium braided into it, the earned wage of bearing the long bond's risk, which the next volume will take up as one instance of the price of risk in general. The volume's question, here, sorts the two: the forecast is judged by its truth, the premium by its justice; and the premium, like every price of time before it, proves a real reward that a sovereign can bend. Having given the price of time its level in the plates before, this plate has given it its shape — a rising line that is at once a map of the future and a schedule of the cost of waiting through it. What that price looks like once inflation is reckoned in — the gap between the rate one is quoted and the rate one truly earns — the next plate must take up; and through it, as the table says of every price, the argument remains open.