Understanding the Yield Curve
Hi monkeys, I am working on a trading desk as a 1st yr but am struggling to understand exactly how to think about the yield curve. I know it is the shape of the borrowing costs for US Treasuries, but I am unsure how to think about it. I know the 3yr and in piece is determined by what people think the Federal Reserve is going to do, but am I just overthinking that from 5yr and out is literally just what the market believes inflation expectations should be at that point in time "X" amount of years from now, 5y to 30y out? There is obviously no credit risk when it comes to US government bonds, only duration/credit risk, so is that really all it is?
i.e. I understand an inverted yield curve is a sign of a recession because market participants believe that the Fed is going to raise rates to cool inflation (and thus 3-5yrs out will be downward sloping because economic growth (and thus inflation) willl come down.... .and a healthy upward sloping yield curve is the idea that there will be economic growth (and later inflation). So inflation expectations seems to be the right answer, but I'm sure I'm missing something. For example, no one can really know 10-30y from now what inflation will be, so what should then drive long-end yields?
Is there any other mental short cuts/heuristics/other ways any of you monkeys think about it to understand it? I understand it conceptually in practice but just how any of you rates monkeys would think about it and maybe explain it in plain English? Thank you!
need to read Ilmanen's Understanding The Yield Curve - just a google search away
Based on the most helpful WSO content, understanding the yield curve, especially in the context of U.S. Treasuries, can indeed seem daunting at first, but you're on the right track with your thinking. Here’s a breakdown to help simplify the concept:
Short End of the Curve (3-year and below): As you mentioned, this part of the yield curve is heavily influenced by the Federal Reserve's actions and expectations. If the market anticipates that the Fed will raise interest rates to combat inflation, short-term yields will rise. Conversely, if the market expects rate cuts, short-term yields will fall.
Long End of the Curve (5-year to 30-year): This segment is more influenced by long-term expectations about inflation and economic growth. While it's true that predicting inflation decades into the future is challenging, market participants use available data and economic indicators to make educated guesses. Factors like demographic trends, technological advancements, and global economic conditions can also influence long-term expectations.
Inverted Yield Curve: You correctly noted that an inverted yield curve, where short-term rates are higher than long-term rates, can indicate a recession. This inversion typically happens when investors believe that the Fed will need to raise rates in the short term (cooling inflation and potentially slowing economic growth), which could lead to lower rates in the future.
Healthy Upward Sloping Yield Curve: This is generally seen as a sign of economic optimism. If investors expect stronger economic growth and higher inflation, they demand higher yields for long-term investments to compensate for the anticipated higher inflation.
Mental Shortcuts/Heuristics:
Practical Application: In your daily work, keep an eye on economic indicators, Fed announcements, and inflation data. Tools like Bloomberg Terminal can provide real-time data and forecasts that help in predicting movements in the yield curve.
Understanding the yield curve involves blending theoretical knowledge with practical market observations. By continuously monitoring market conditions and economic indicators, you can refine your understanding and become more adept at anticipating changes in the yield curve.
Sources: Insights on Fixed Income Trading, The ‘Business Cycle’ framework, Factors that affect 10yr and 2yr treasury yield, Insights on Fixed Income Trading, You Ready? | The Daily Peel | 1/11/21
Hi,
So long end rates in simple terms are a function of long-term neutral rate, inflation expectations, and term premium. The long-term neutral rate is what kind of anchors you're long term expectation of policy rates - if the Fed's goal is to keep the economy growing in line with potential GDP. It should average out to be the neutral rate. Inflation expectations is fairly self-explanatory as far as how that factors in. Term premium is trickier, and like the neutral rate, not directly observable (i.e. model-based estimates at best). Term premium in theory is driven by the relative extra yield investors need to lock up their money for long periods of time (compensation in case rates end up higher than expected over the time period) or the yield they are willing to forego to guarantee themselves a fixed rate right now (hedge against rates ending up lower than expected over a long period of time).
In practice, a lot of "term premium moves" are driven more by supply and liquidity dynamics, especially at the long end.
Looking at the curve today, the policy rate is significantly higher than what the Fed currently thinks is the neutral rate. If we assume that the neutral rate is indeed somewhere between 0%-0.5% real and inflation will average back out to 2%, the risk neutral 30-year old should be about 2.5%. Of course, investors are not risk-neutral - buying 30yr bonds entails fairly large duration risk for which you'd want compensation in the form of additional yield, and between higher for longer narrative and inflation potentially being sticky at 3%, it probably makes sense to demand positive term premium.
But is that term premium demand high enough to make a fully upward sloping yield curve? Liability-driven investors who need long-dated bonds only have so many options to meet that need, and while long-end supply probably does en up growing over time, if it's not growing significantly faster than the demand for long-dated bonds that will limit how high long-end yields should get. It doesn't help that long-dated bonds often end up with buy and hold to maturity type accounts - it's less of a two market at that part of the curve and lack of ability to source bonds on margin should put some downward pressure on yields.
Hope that provides some food for thought at least.
SB’d, thanks for sharing, that was helpful. I spent the last six months at a macro fund and was confused by the steepener trade. Any advice what I should do to understand the ins and outs of the yield curve? Things to read or follow?
🙏 thanks for explain the yield curve, brother
Hi,
In terms of understanding a specific curve trade, pay attention to Fed speak, and think through why specific points on the curve might be biased to move a direction.
For example, consider the steepener trade.. why should you be biased to think long end rates might move higher? The fed is currently saying they view rates as restrictive, but evidence points towards either 1) inflation staying stuck at 3% despite current rates level. Would push upwards inflation expectations 2) If the fed eases into sticky inflation. Long term inflation expectations should move up. Either way, the long end moves higher vs. Where it is today
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