What Is The Yield Curve? Why Is It Important? 10
It is widely believed that the Fed only controls “short term” rates. “Short term” in conventional market wisdom means up to the 2 year mark on the yield curve, that is, US 2y yields.
Hence, yields up to the 2y mark are “supposed” to move the most when the Fed changes the Fed Funds Rate.
By extension, longer term bonds are seen as sitting outside the Fed’s zone of “influence”. Which simply means that the longer tenor the UST, the less it is affected by the Fed’s interest rate policies.
For the sake of specificity, since we have emphasized that the Fed doesn’t really matter: the longer tenor the UST, the less it is affected by the market’s Pavlovian reaction to the Fed.
This key difference between 2y and 10y USTs is where the Fed’s policies meet economic and market reality.
Since the Fed “controls” the front end of the curve, and not the back, the spread between short and long term yields (like the 2s10s) actually indicate to us what the market thinks will happen in the broader economy.
What’s happening in the yield curve now provides us with a good example of this. US 2y yields are rising by more than 10y yields, which has given rise to a flat yield curve that inverted across multiple tenors in early April.
2y yields are rallying strongly as the market responds to the Fed’s continued jawboning and uber-hawkish rhetoric. 10y yields, however, are not as sensitive to all of this, and aren’t rallying as quickly.
What is truly striking is that the rally in 10y yields can’t keep up with the rally in 2y yields, even though inflation is running very high. (recall that 10y yields are much more sensitive to changes in inflation) 2s10s falling below 0 in early April proved this.
Logically, if 2y yields rise above 10y yields during a hiking cycle, it means that the market is pricing in a rate of long term inflation that is lower than Fed driven short term interest rates. In other words, the market is not expecting the economy to grow. At least not to the point where it generates enough “good” inflation.
It is this “ability”of the yield curve to absorb and distill complex global market interactions, while still acting as a reliable early economic warning system, that makes it so invaluable to traders and investors.
That being said, the yield curve should not be taken too literally. Firstly, it can’t really tell us how deep a future recession will be, as explained earlier in this series.
Secondly it is a market based measure, which means that it is susceptible to short term market “noise”. As such, it isn’t the case where the yield curve will, once inverted, stay inverted until recession comes along.
Instead, it bounces around like all other market prices, first inverting, then un-inverting, and possibly re-inverting again. The key here, as it is with trading every other market, is to focus on the trend, not the short term event driven gyrations.
Ultimately, for all the yield curve’s limitations, and our inability to figure out the complex web of individual market interactions that drive it, a broad macro view of what its shape represents is enough for general purposes.
Of course, investigating and understanding the nuances of what moves UST yields, and hence the shape of the curve, will give one greater insight into how global markets function. But, for those less inclined, understanding what flat, steep, and inverted represents is good enough.
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