Author: Steven Klose

No… not crop yields, we are talking about bond yields and rising interest rates.  As the Federal Reserve began battling inflation a little more than a year ago with interest rate hikes, Dr. Anderson and I discussed the progression of inflation, interest rates, and the nature of yield curves in a series of articles here on Southern Ag Today.   Over the course of the last 14 months, the Fed has incrementally pushed the Federal Discount Rate to 5.25% as of late May 2023, up from 0.25% in March 2022.  

In “Careful on the Curves” from July 13, 2022, we described yield curves for Treasury bills/notes.  Without repeating too much of that discussion, the yield curve is simply the structure of market interest rates or yields for instruments (treasury bills or corporate bonds) with varying maturity dates.  The shape of the yield curve can reveal a sense of what the market expects with regard to inflation and future economic conditions.  

Typically, yields increase as the maturity length of a financial instrument increases creating an upward sloping yield curve.  This fairly normal yield relationship reflects the expectation that investors require a higher yield to commit to longer-maturing investments but also suggests relative stability in other factors, such as inflation, economic growth, and market volatility.

Figure 1 shows the progression of the yield curve at the end of each quarter from September 2021 through May 2023.  In today’s market, we find the unusual (up-side-down) inverted yield curve where long-term yields are below short-term yields.  By September 2022, the curve between 3Yr and 10Yr maturities was inverted.  In December 2022, the inversion progressed to cover 6Mo to 10Yr maturities.  In the first quarter of 2023, longer-term rates declined relative to Q3 & Q4 of 2022.  Combined with continued upward pressure from the Fed on short-term rates, today we see the strongest downward sloping curve spanning 1Mo to 10Yr maturities.

There is a well-known quip that economists have predicted 10 of the last 5 recessions.  That line is particularly apt in a discussion of the yield curve.  An inverted yield curve has frequently been a precursor to recession – that’s why people take notice when it happens.  Unfortunately, there is no such thing as a sure thing when it comes to economic indicators; which is too bad because that would make economic forecasting a whole lot easier.  What the inverted yield curve tells us for certain is that the current economic situation is particularly uncertain.  As we write this, the market is trying to figure out how the government is going to navigate the imminent approach of the debt ceiling limit, whether the Fed will continue on their path of raising interest rates, and what OPEC plans to do with oil production.  And those are just a handful of the big-ticket items in play.  These significant market events will be taking place within – and being influenced by – a domestic and international political situation that is tense, to say the least.  So what is a decision maker to do with the inverted yield curve?  The old adage ‘hope for the best, prepare for the worst, comes to mind.  More concretely, that means preparing for two or three quarters of recession (e.g., by minimizing exposure to short-run interest rate risk and protecting equity).  While a recession is not a foregone conclusion, the probability is too high to prudently ignore.

Figure 1.  Treasury Yield by Maturity: Selected Daily Yields, 2021 to 2023

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Interest rates and inflation are closely linked phenomena.  As we discussed last week, expectations about inflation can provide insights to the direction of our overall economy.  The yield curve is another place where the market interest rates reveal a sense of what the market expects with regard to inflation and future economic conditions.

The yield curve is simply the structure of market interest rates for instruments (treasury bills or corporate bonds) with varying maturity dates.  Ordinarily, the yield curve is expected to slope upwards: that is, as maturity length on a financial instrument increases, the yield on that instrument increases as well, reflecting the normal expectation that investors have to receive a higher yield to commit to longer-maturing investments.  In addition to the higher real interest and risk premiums associated with longer-maturing investments, expectations about inflation are embedded in the relationship between time to maturity and yield. 

A steep yield curve (longer term rates are much higher than shorter term rates) can suggest the market expects higher inflation, economic growth, and/or volatility.  A flatter curve (little difference between short and long term rates) can signal lower inflation expectations and more stability.  Sometimes the yield curve inverts or slopes downward, with yields declining as maturity increases.  An inverted yield curve signals expectations of deflation and is a fairly reliable indicator of an impending recession.  

Figure 1 shows the yield curve for Treasury bills/notes with maturities from one month to 10 years for the last day of April 2022 compared yield curves from February 2020 and November 2007. 

Figure 1.  Treasury Yield by Maturity: Selected Daily Yields, 2007 to 2022

Clearly, in the recessionary environments of 2007 and 2020, the yield on long-maturity instruments was much lower relative to short-maturity instruments than would generally be expected.

Recent changes in the shape of the yield curve trace out the development of inflation expectations in the post pandemic period.  Figure 2 shows the daily yield curve in two-month intervals beginning with the last trading day in August 2021. 

Figure 2.  Treasury Yield by Maturity: Selected Daily Yields, 2021 to 2022

Not only have rates increased since last summer, but the slope of the yield curve has changed.  For maturities ranging from 1-month to 2-years, the curve has grown considerably more steep as of June 2022, likely indicating expecations of a continued struggle with inflation in the near term.  However, for maturities over the range of 1-year to 10-years, the curve has become flatter (compare October 2021 with June 2022).  The yield curve has not inverted as, for example, in 2007, which would suggest strong expectations of an imminent recession.  However, the longer term portion of the curve becoming flatter suggests an outlook of at least a slowdown in the economy that eventually gets inflation under control. 

Klose, Steven and John D. Anderson. “Careful on the Curves.” Southern Ag Today 2(29.3). July 13, 2022. Permalink

When referencing prices, nominal simply means the actual quoted price of a good at a given time.  Real is a concept used to remove the inflation effect on prices and compare the true value of a good in different time periods.  For example, the US average price of gasoline recently hit $5/gallon.  To truly understand how expensive today’s prices are, we would have to account for inflation and adjust past gas prices to be quoted in 2022 dollars.  The inflation adjustment makes it a “real” value comparison.

Real and Nominal also have a unique meaning when it comes to interest rates, and again inflation is a key component.  Nominal interest rates are the value you see quoted for a loan, a certificate of deposit, or yield on a bond.  The total nominal interest rate is made up of several components: the real interest rate, a risk premium, and expected inflation.  The real interest rate is the underlying cost of using someone else’s capital for a period of time.  The risk premium accounts for the uncertainty of the loan due to the credit worthiness of the borrower and/or how the loan is to be used.  Finally, expected inflation is added to account for the change in purchasing power between original loan proceeds and the loan repayment at a later date.  If, for example, a lender was expecting 5% inflation over the next year, the real interest rate was around 1.5%, and the risk premium was another 1% (the lender thinks the borrower is a trustworthy fellow), he would quote a nominal interest rate of 7.5%. 

Expected inflation is an important part of the greater economic picture today.  Peoples’ feelings and expectations about future inflation influence how they buy, sell, borrow, lend, and negotiate prices in the market place.  In no small part, expected inflation can create a self-fulfilling prophesy.  All of this brings us to an interesting bit of economic data that gives us a hint at today’s market expectations for inflation.  Nominal interest rate quotes are readily available, but the components as described above are not transpartent in those quotes; at best, they can be estimated.  One such estimate is known as the TIPS spread or the 5-Year Breakeven Inflation Rate.  TIPS refers to Treasury Inflation-Protected Securites which are adjusted to offset inflation.  The nominal yield for regular Treasury notes includes real interest rates, virtually no risk, and market expectations for inflation.  The yield on TIPS has the same components but excludes expected inflation, therefore the market’s expectation of inflation is revealed in the spread, or yield difference, between the two types of notes.  Figure 1 shows the TIPS spread on five-year Treasury notes over the past twenty years.  The TIPS spread quickly rose from near zero at the onset of the pandemic to a high of 3.5% in mid to late March.  The spread has since fallen back to around 2.75% as of last week.  The decline over the last three months coincides with the Fed’s more aggressive action to fight inflation.  It’s too early to tell if the Fed’s higher interest rates are slowing down inflation, but this early indication in the TIPS spread suggests market expectations are improving with regard to inflation.  If your glass if half full, it’s an encouraging step it the right direction.  If your glass is half empty, a decline in inflation expections also reflects a growing concern about a future recession.  In reality, both interpretations are relevant regardless of how much water is in your glass.    

Figure 1. Daily Yield Difference between Regular and Inflation-Protected 5-Year Treasury Notes

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Klose, Steven, and John D. Anderson. “Influential Expectations.” Southern Ag Today 2(28.3). July 6, 2022. Permalink

The Southern Ag Today team of editors and contributing authors are, for the most part, a group of Extension Agricultural Economics Faculty from the Southern Region Land-Grant University Systems.  Many of this same group are responsible for a decades-old tradition of publishing crop and livestock enterprise budgets in their respective states or regions.  Extension budgets are typically published early in the year before the growing season starts, and they serve a number of purposes.  The first is to simply provide examples of common practices used in region-specific enterprises, as well as to illustrate a possible set of revenue/costs expectations for the coming year.  Ag lenders sometimes rely on these budgets as benchmarks to compare loan applications and borrowers’ production plans.  Various state and federal agencies and other agricultural industry researchers may use these budgets to compare practices, costs, or expected yields across regions and over time.  However, most of us that contribute to creating Extension budgets would consider those as secondary benefits.  

Extension budgets are best used as a planning tool, and even better if you make them your own with the published budget serving as a guide.  To that end, many of our budget projects also offer downloadable spreadsheets and other tools to create your own budgets.  The pre-season budget planning process offers a number of management benefits, including the ability to:

• compare potential profits of various enterprises or production plans and choose appropriate crop mixes.
• assess cost of production and break-even prices/yields; which help develop marketing plans and select appropriate levels of insurance.
• conduct sensitivity analyses on specific items.  For example, determining the impact of recent fertilizer price increases on expected net returns and evaluating potential production plan adjustments.  

Another benefit to a formal spreadsheet budget is the ability to do what I call active or continuous budgeting.  The idea being that the budget and the budgeting process does not end when the growing season starts.  As you progress through the production season, planned expenses become actual expenses while yield and price expectations are constantly changing.  Incorporating these in-season changes into your budgets as you go will keep you mindful of cashflow needs and will assist with ongoing production and marketing decisions.  The process will also sharpen your management skills and improve your pre-season production plans in future seasons.  

To find budget publications and resources in your area, click below for your state’s Land-Grant University Extension program.  

Alabama             https://www.aces.edu/blog/tag/profiles-and-budgets/?c=farm-management&orderby=title

Arkansas            https://www.uaex.uada.edu/farm-ranch/economics-marketing/farm-planning/budgets/crop-budgets.aspx

Florida  https://fred.ifas.ufl.edu/extension/commodityenterprise-budgets/

Georgia              https://agecon.uga.edu/extension/budgets.html

Kentucky            https://agecon.ca.uky.edu/budgets

Louisiana         https://www.lsuagcenter.com/portals/our_offices/departments/ag-economics-agribusiness/extension_outreach/budgets

Mississippi          https://www.agecon.msstate.edu/whatwedo/budgets.php

North Carolina   https://cals.ncsu.edu/are-extension/business-planning-and-operations/enterprise-budgets/

Oklahoma          http://www.agecon.okstate.edu/budgets/

South Carolina   https://www.clemson.edu/extension/agribusiness/enterprise-budget/index.html

Texas                  https://agecoext.tamu.edu/resources/crop-livestock-budgets/

Tennessee          https://arec.tennessee.edu/extension/budgets/

Klose, Steven. “Extension Budgets and Budget Tools“. Southern Ag Today 2(18.3). April 27, 2022. Permalink

After years of stable and low inflation and an almost unprecedented stretch of steady economic growth, our economy is now experiencing the highest inflation we’ve seen in over 30 years.  No doubt you have seen Jerome Powell, Chair of the Federal Reserve System Board of Governors commenting on actions taken to curb inflation.  With recent inflation running in the neighborhood of 8% as measured by the Consumer Price Index (CPI), response by the Federal Reserve (Fed) will continue to be front page news and will be critical to economic conditions moving forward.  In that light, I thought a brief overview of the players, tools, and terms might be helpful. 

Inflation most simply defined is a general rise in prices of all things, including consumer goods, manufacturing goods, and labor.  The simple cause has been described as “too many dollars chasing too few goods.”  Right now, we have that problem from both sides.  Goods and labor are both in short supply, while there is an abundance of consumer demand and government spending (dollars eager to be spent).  Limited supplies of goods and labor push up prices and wages.  Higher prices and an abundance of dollars effectively lowers the value of each dollar.  Inflation is mostly problematic because it happens in “spits and spurts” with some prices rising faster than others creating winners and losers, instability, and economic uncertainty.  Uncertainty drags down consumer confidence, business investment confidence, and therefore economic growth.  The scary part about inflation is its ability to gain momentum as a vicious cycle or a self-fulfilling prophecy.  As people and businesses adjust to rising prices, they often do so by raising other prices to compensate for the increased expense.  People’s expectations also play a huge role.  If everyone expects inflation over the next year or two, their business negotiations and price setting choices will reflect their expectations and some portion of inflation can be blamed on the fact that people “thought” we would have inflation. 

The Federal Reserve System is our country’s central bank responsible for managing, among other things, our currency, or the money supply.  From the Fed website, their purpose is providing “…the nation with a safe, flexible, and stable monetary and financial system.”  They have a few tools in their belt to manage the money supply, influence the value of the dollar, and keep a check on inflation.  In a recession or slow-moving economy, a central bank may push monetary policies described as expansionary or accommodative.  In other words, they are doing things to stimulate activity such as business investment, employment, and consumer purchasing.  In our current situation, to fight inflation the Fed has started actions to tighten the money supply, or what is called contractionary policy.

By far, the tool you will hear the most about is what the Fed is doing with short term interest rates.  The Fed sets a target range for the Fed Funds Rate, which is the interest rate banks pay to borrow overnight funds.  As a benchmark, the Fed Funds Rate establishes the availability of money and influences other short term cash markets.  When inflation is driving down the value of the dollar, the Fed will increase interest rates to make borrowing more expensive, slowing down the supply of money to increase or support the value of the dollar.  Since the onset of the pandemic, the Fed Funds Rate sat on a range of 0.00% – 0.25%.  On March 17, 2022, the Fed bumped the range up a quarter of a percent to 0.25%-0.50%.  The have also announced their intention to continue increasing the rates steadily throughout the coming year.  They will often signal their future actions to avoid surprising financial markets, instill confidence, and dampen inflation expectations. 

Open market operations refer the Fed buying and selling of treasury securities.  The buying or selling of short-term securities are moves used to help achieve the targeted Fed Funds Rate.  The Fed may also buy and sell longer term assets, such as 10-year Treasury Notes.  In either case, Fed purchases pump money into the system and the Fed holds the security as an asset.  On the other hand, if the Fed is fighting inflation, they may sell securities and park the cash on their balance sheet to effectively reduce the supply of money floating around in the economy with the intent to make each dollar more valuable.    

On the surface the problem seems basic.  When there are too many dollars as we have now, you take some money out of the system.  In reality, the system is incredibly complex and drives much more like a barge than a sports car with the Fed nudging the money supply, interest rates, and the economy in one direction or another.

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Klose, Steven, and George Knapek. “Too many Dollars Chasing Too Few Goods.” Southern Ag Today 2(15.3). April 6, 2022. Permalink