How to Read a Yield Curve
The US treasury yield curve is fundamental to investment analysis because it captures the bedrock of market belief — the cost of capital over time. Knowing how to read this information can yield powerful insights about market expectations.
The “yield curve” refers to a graph of treasury yields for different durations (lengths of time). The one we’re looking at here is from the beginning of September 2022.
Why the Curve?
Here’s a question: why does it curve at all? That is, why do interest rates vary based on the duration of the loan? If we’re willing to lend 2% for a year, why not at the same rate for 3, 10, or 30 years as well?
Lending money involves risk and different periods in the future carry varying perceptions of risk. Generally, it’s thought riskier to extend loans for longer periods of time as this gives the borrower more opportunity to default. Extending this logic we’d expect that interest rates should rise as we move down the curve (to longer durations). Yet, yield curves do not always reflect this thinking. Why is that?
Thinking Caps: On
Join me on a thought experiment. We have some money we’d like to put to work. Let’s head to our favorite broker to check the available rates for US treasuries. Here’s a sample of rates at different durations taken from our curve above for 9/1/22.
As an investor who would like to maximize returns we might wonder why anyone would not choose to invest at the 20 year duration since it yields the most at 3.64%. One reason could be 20 years is beyond our investment horizon.
Let’s say we are looking to invest for only 5 years. What should we buy? The 5 year yielding 3.39%, right? Hang on, it appears we can get a higher yield of 3.54% if we buy the 3 yr instead. Though we’d have to figure out what to do with the money for years 4 and 5 since we want to continue earning interest. But why are we being offered a higher yield for a shorter duration?
This leads us to an important point about rate comparisons. Rates must be compared over the same investment period. Let’s see why this is and what that means to our example.
We go ahead and purchase the 3 yr note, attracted by the highest yield that fits in our five year investment window. We make 3.54% — for 3 years. After 3 years we get back our principle and need to redeploy it .We’re now at the mercy of market rates three years forward. The risk we’ve realized is that our options for reinvestment may yield less than the rate we had locked in during the first 3 years. This is known as reinvestment risk.
We can now appreciate one reason why an investor would opt for the 5 yr instead of the 3 yr due to the added risk of reinvesting in a 2 yr at a lower rate. But how much less would the 2 yr note have to yield for us to be worse off than taking 3.39% over 5? With some straightforward analysis we can answer this question and gain additional insight to market expectations. This is the power of the yield curve.
Equality for All, Rates Included
Let’s look at the 3 and 5 year here. Our fixed-term yield on the 5 yr is 3.39%. So investing $100 at 3.39% over five years returns us
$100 *1.03395 = $118.14If instead we purchased the 3 yr we would have
$100 * 1.03543 = $111.00This takes us to the end of year 3. We now want to know the 2 yr rate that would turn our $111.00 into the $118.14 that the 5 yr returned in total
*abacus swirls*
sqrt(118.14/111) - 1 = 3.17%So our breakeven rate for reinvestment in the following 2 yrs would be 3.17%. This is also known as the implied 2 yr rate for three years forward (3F(2y)). Which is really another way of saying that the market expects that in three year’s time the 2 year will yield 3.17%.
Said another way:
5 yr = 3 yr + 3F(2yr)As you may now be getting, we can compose any longer term note into shorter durations along the same time period using implied forward rates. While these shorter duration notes may vary in yield, they will ultimately combine to yield about the same as the single longer term note. It won’t always be perfect but material deviations will be arbitraged away as the treasury market is the most traded market in the world. In fact, the forward market for interest rates is estimated to total over $500 Trillion in notional value.
Get Shorty
Returning to our yield curve, let’s look to the shorter end. The math works the same down here too. For example, a one week bill can be reproduced with the overnight spot market rate and a 6 day rate lock, 1 day forward.
Now we’ve hit bedrock. The overnight spot market, the rock on which all other yields rest. To this point, we’ve seen where yield at longer duration comes from, having built equivalent treasuries out of shorter duration notes and implied forwards. What about the overnight rate — the keystone of the curve? How does it get set and what factors influence it?
The Fed, America’s Institutional Scion
While our markets may be free, they rest on a centrally planned rate. We’re talking about the fed funds rate which acts as an overnight lending benchmark. Overnight lending is a massive market. The St. Louis Fed tracks the data here. At last reading it stood around $282B.
To those outside of finance the idea of overnight lending must be odd. After all, the only time consumers borrow money overnight is for payday loans and bookie debts. (“I got your money tomorrow. I promise.” Of course.)
In the world of banking, there are far less questionable needs for overnight capital. It centers on the reserve requirements that banks must meet. The Fed, responsible for banking oversight, requires banks to hold a certain ratio of assets against their outstanding liabilities. As banks wind down for the day and books are balanced, some will be short of these requirements and need to top up their coffers. On the flip side, there will be banks and investors who have a surplus of capital and would like to earn yield on it without making a longer term funding commitment.
The overnight rates banks charge each other to lend is based on the fed funds rate which in turn is set by the Federal Open Market Committee (FOMC). This is a group of Fed officials who meet 8 times a year to discuss monetary policy. Any change in policy is then communicated to the market at the conclusion of their meetings. It would help us as investors to gain insight as to how this committee governs and what causes them to move policy.
Policy Shifts
Conceptually, monetary policy *should* act as a counterbalance to the economy. Policies that follow this thinking are countercyclical. The thinking goes that when the economy is too hot (excessive speculation/asset inflation) the Fed will raise the overnight rate and sap investment capital from the more speculative markets into higher yielding debt.
Likewise, when the economy slows they’ll lower rates to boost the economy as investors deploy cheap capital into riskier assets in search of yield. It’s really that simple in theory — an equation could do the job. Though in practice, it’s more complicated for both technical and political reasons, though this countercyclical response model will serve us well for now.
Two for One
For a more contextual reading of the yield curve, it can be helpful to review . what the curve looked like in the past. Let’s look at how our September 2022 curve has changed over the past month.
For starters, rates have gone up across the entire curve — and not by a small amount. Last month was, in fact, an outlier by historical volatility measures. So the cost of capital has gone up for all borrowers at all durations. Looking at the short end, it appears the new curve has become steeper. We may conclude from this that not only have rates risen, but the market expects for them to continue rising at a pace even faster than was thought last month. This response is indicative of a Fed that has signaled and demonstrated their intent to raise rates swiftly. Indeed, this reading certainly maps to reality.
Miss Cleo’s Curve
The two questions on most investors’ minds at the moment are 1) how high will rates go? and 2) how long until the Fed has to shift their policy stance? Can we uncover what the market believes about these questions using the yield curve? Would I ask that question if the answer weren’t yes?
Note the plateau around 4% six months out, this is about the time markets expect the first policy shift from raising to holding rates. Between the 6 month and 3 yr period markets expect the Fed to hold rates steady. Finally, the downward bend after the 3 yr implies the second shift in policy to cutting rates.
“Because I Was Inverted”
This downward bend is an important point in the curve because this is where it “inverts”. The market anticipates the Fed will be forced to reverse policy and begin lowering rates which portends a faltering economy. That the curve then declines for the next 7 years is concerning because it says the market sees the Fed only lowering rates over that period. Again, due to expectations of a struggling economy.
What you’d like to see is a brief dip in rates followed by a steepening in the curve no more than a year or two out. This says that yes, rates did have to come down to shock the economy back, but just as with people, getting off life support is a good thing. And that rates are seen coming up after just a year or two says the market has confidence that while tough times are ahead, there’s confidence the economy can pull through intact.
An inverted yield curve (10 yr yields less than 2 yr) is such a reliable indicator for economic conditions because it captures the mood of future expectations in a way few others can. Let’s look at a more typical yield curve for comparison.
*Note: The 20 yr yield is artificially high because of liquidity issues, its recent introduction has not been as well received as hoped and the market is not as deep as other durations and trades at a slight discount.
Let the Good Times Roll
As an investor this yield curve from May 1994 excites me. Living in a country with a curve like this would be exciting. But why? Aren’t higher interest rates bad for the economy? Yes, lower rates would certainly be more stimulative, but it’s the shape of the curve that says “here’s an economy so strong that not even rising rates can slow its ascent” because investors are willing to believe the narrative this yield curve tells. Interest rates are projected to rise seemingly without pause and an economy so strong that investors find a world where rates rise and the economy absorbs them like a worn down speed bump. When presented the opportunity to earn 7% risk-free for 10 years, many will still choose equities, implying even greater expected returns.
Source: Macrotrends
And looking back on this period of time, the implied forwards were not ultimately right across the curve (they rarely are) but look at the upward inflection the market took around the time of this snapshot in ’95. Certainly a wonderful time to have been invested in US equities!
One Curve to Rule Them All
With some luck, you’ve picked up an insight or two about the way we price money and how it plays into the market’s reference narrative. Being able to make sense of the yield curve for yourself is an invaluable skill as an investor. Like being able to speak a second language and not having to rely on a translator, you can pick up nuances otherwise lost when at the mercy of another.
There are no hard and fast rules about what any particular movement or shape means. Markets are living in the sense that they are always searching for novel solutions to economic conditions and will occasionally confound us. Remember, markets are never “wrong”, it’s only our understanding of them that is. It’s in these cases that being able to think for yourself can be profitable if you can make sense of it before the rest of ’em. Godspeed.
MJS
Originally published at https://mattstarolis.com on October 6, 2022.
