Markets in general are typically human-behaviored-like, as they display and show to the advised reader every information needed in order to predict future prices. Though, in my opinion many look at the wrong side of the board by watching straight raw stock prices without a narrative attached to the idea behind the latest price movement.
Through this article, I will try and let you know about what is in my opinion the most complete and elementary piece of information you can extract from the market itself; giving you a deeper understanding of the current sentiment and conditions felt by the biggest actors in the game, in the largest market known, as said the bond market.
Let’s dive in
What is a Bond Yield Curve ?
First, in order to understand the bond yield curve, you obviously need to understand what a bond is, and the different types of bonds issued on the secondary market.
To make it simple, a bond is simply a debt title, stating actor A owes *x amount of money* to actor B considering some information. The main one being the due date (whether it’s in 2 years, 10 years or 30 years for example), the current financial state of whom is in debt (investors try to measure its capacity of repayment), and finally the price of the bond itself, which is proportionally inverted to the yield rate at which the debtor has to pay (when the price of the bond increases by x%, the rate decreases by kx%, k here being a constant)
Considering that, what you also need to know is there exist basically 2 types of bonds : corporate and government bonds. They both serve the same function and are almost identical in every way.
Although here we are only going to look forward to the second one, as we try to oversee a very global macro view on the market and its sentiment, not a corporate view of it. The bond market being the most liquid market, I believe it is important not to ignore it.
Therefore, bonds are looked differently regarding their expirations date, following the same logic used by markets since their creation : ‘the more you risk, the more you are likely to gain big’ (here I won’t talk about how this is not proportional regarding every market). Taking this information into account means investors will forecast their estimations and scenarios only far enough to attain the expiration date of the bond itself.
All of this is important to note to understand how we then proceed to draw a curve. The abscissa represents the years till expiration and the ordinate is about the yield provided by the bond. Regarding this we need to look at the shape of the curve, which will give us insights
In a healthy economy, the curve would take a logarithmic-like shape, as investors are confident enough to lend on the short term, therefore signaling a healthy global analysis, but tend to hedge themselves on the long run regarding the longevity of the due dates caused by the unpredictability of the markets (up to 30 years ahead).
By extension, the top of the curve being at the far right of the graph is significantly meaningful as it shows what the market estimates as the most ‘dangerous’ or risky moment in the lifespan of a bond.
That would then make sense to have a top of the curve at the total end of it in a healthy market condition, as the biggest uncertainty comes from the future itself, and not the actual forecast of a near event.
Now let’s define this state as the default basic state of the curve in which the macro conditions are predetermined ‘normal’.
The shape of the curve can also invert, as that would represent a greater risk of recession felt by actors, inflationary pressures or whatever poor monetary expectation. The yield brought by the shortest bond terms is higher than the longer. The market expects a downfall soon, followed by some sort of relative optimism regarding the long term periods.
This phenomenon is very self telling : trust is falling and sentiment over the next few months/years isn’t hopeful. For example, since the 1960s, out of the nine times the
US Treasury yield curve has inverted, eight have preceded a recession.
Here on the graph, you can see it’s not the historical yield curve in itself, but the subtraction of the 10 years yield by the 2 years yield, which is basically the poor man’s way to evaluate this event, as there exist no other way to see it other than professional tools (TICKER TradingView : US10Y-US02Y). Though, the point remains the same as a decrease of the US10Y-US02Y automatically implies an inversion of the yield curve.
Today, the curve has begun its inversion (see graph on the left below) and we can expect it to go even higher regarding the current state of the monetary policies set in place by the Fed.
That being said, the market can implement both types of curves regarding the current macro situation, but what about changing slightly the shape of the same curve ?
Let’s have a look at the steepening and the flattening of the yield curve
Regarding the steepening of the curve, it is said to occur when investors require a high risk premium to lend on distant maturities to compensate for a risk of inflation or future budgetary slippage that they consider higher than the current level.
The steepening of the yield curve is therefore associated with expectations of an increase in inflation over time or a deterioration in the budgetary situation. One could associate that newly formed shape to a switch in mindset perceived by the market : a more pessimistic way to see things, as we could interpret.
But how about a flattening of the curve ?
There are several potential explanations for the flattening circumstance. In particular, a shift in investors’ expectations for the level of long-term interest rates might be the cause, or a newly established easing. For instance, the premium needed to purchase long-term bonds would decrease if they anticipate a decline in inflation in the coming years.
The interest rate curve however, can also flatten as a result of other factors. Particularly, when a state’s fiscal condition improves, the likelihood that it would experience a medium- or long-term default declines, which lowers the risk premium that investors must pay to purchase its securities issues with the longest maturities.
Though, the shape can remain the same and/or keep on increasing the optimistic way to see it while yields themselves increase ! If the whole curve stays visually the same by a proportional relation, but each point of maturity increase by 200bps, the conditions will inevitably worsen as they tend to globally increase.
Thanks for reading me, if you have any questions you can always dm me on Twitter, I will answer.
Have a good week everyone take care ❤
