The Yield Curve

What is a yield curve?
Investopedia defines a yield curve as: a line that plots yields, or interest rates, of bonds that have equal credit quality but differing maturity dates. The slope of the yield curve can predict future interest rate changes and economic activity.

What is the yield curve?
“THE yield curve” refers to the spread the between the yield on a 10yr treasury and a 2yr treasury, whether that is a US Treasury (“UST”), Japanese Government Bond (“JGB”), or a German Bund (“Bund”). For the rest of the post, let’s just work with USTs, although JGBs currently look like they will take the spotlight for the remainder of the year.

The yields on government debt securities is a function of the federal funds rate in that country (assuming the government is borrowing money in its sovereign currency); generally, f(x) = fed funds rate (%) + various risk premia (%)

Yields, Yields vs. Fed Funds Rate, Yield Curve
Looking at UST yields reflects how much the US has to pay to issue debt at various maturities. As stated above this is a function of the federal funds rate and various risk premia charged by the market to account for: opportunity cost, default risk, interest rate risk, among others.

The various yields required by investors at different maturity dates (and how this changes over time) reflects many factors of investor preference and how the curve changes over time can reflect the sentiment of the markets. Take the following yield curves which show various maturities on an annual basis from June 2020 to June 2023 (from bottom to top).

Inversion/Reversion - complicated topic, will try my best and may need to come back to this as a standalone topic

What is yield curve inversion and why does it matter?

The yield curve is inverted when long terms rates fall below short term rates. Typically an investor would expect long term rates to be higher than short term rates to compensate investors for the additional risk they are taking in accordance with the additional duration. So, investors take notice when the opposite is happening.

Every market is different, so in one market the yield curve inverting may indicate a flight to safety (in long duration USTs). Right now, there is an argument being made that the inversion is investors pricing in the end of the Fed’s inflation battle. Either way, inversion means that yields are lower in the longer duration issuances, which investors prefer because the UST is considered to be risk free. Although ironically, the US Debt has been downgraded (now AA+/AAA versus AAA/AA+, a minor but meaningful distinction) as I write this, for the first time since 2011.

Yield curve inversions matter because at some point, the curve will “revert” and that appears to be the true recession signal. However, all one hears about in financial media is the inversion and never the reversion. Using data from Fred, we can see that inversions precede reversions which nearly directly precede recessions. If investors hedge every time the yield curve inverts, they will end up being “early” (read: wrong) to the recession trade.

It is easy to see that we have been heavily inverted for a significant period of time now. From a recession timing standpoint, I am looking for the 10yr-2yr inversion to start making its way back to 0, at which point it would be time to think about buying $TLT.

In response to the debt downgrade which happened overnight on 8/1, the equity markets sold off today, and while $TLT opened with a significant gap down, $TLT showed strength all day while the equity indices shows persistent selling.

I will want to see more trading before deciding for sure, but the downgrade news could be just the catalyst that a jittery market needed to back/fill — for what it’s worth, $SPY and $QQQ have left tons of gaps behind over the last 2.5 months. None of these gaps have to fill, but as price approaches a gap it is likely to at least test the gap, if not fill it entirely.

Steepening Trades

The problem for debt investors is that what started as a clear bear steepener (long maturity rates rising quicker than short maturity rates) quickly became an even more aggressive bear flattener (short maturity rates rising quicker than long maturity rates). This is of course only clear in hindsight. The question for debt market participants (the outcome of which will be quite relevant for equity participants) is whether the bear flattening will continue, or if it will revert into a bull steepener. And, that is where this story intersects with GDP, inflation, and payroll/unemployment “prints”.

When coming out of complete zero-interest rate policy (ZIRP), the first move has to be a bear steepener since the entire yield curve is on the floor, at 0%, and governments would never raise short term interest rates unless their hand was forced by inflation. As inflation expectations rise, investors sell long-term treasuries to invest in the market which drives price down and causes long-term rates to rise (bear steepener). As inflation picks up, central banks will inevitably raise rates to cool the economy, which leads to a bear flattener. That is where we are today. The question is simply whether the fed will keep rates high (or raise them nominally) → more pain for those long bonds, or if the economy will slow causing the fed to start lowering rates to stimulate growth and attempt to fend off a recession.

Here’s a handy chart on steepening trades. Just remember “flattening” is moving the yield curve towards a 0-180 degree line, while “steepening” is moving towards a 225-45 degree line (recall radians, also pasted below). As for bull/bear, consider if you were already long bonds and had to sell them at the market immediately after the curve shift (i.e. yields down, price up, bullish or v/v).