Friday, January 24, 2014

Steepening Yield Curve Of US Bonds: What Does It Mean?

Recently, there has been a renewed focus on the yield curve and its implications for future economic growth.  Analyzing the movements in the curve can provide investors with insights into economic forecasts and trading opportunities across multiple markets.

The US Treasury Yield Curve is simply a graph of different treasury instruments and their respective yields, with their time until maturity on the horizontal axis, and their yield on the vertical axis. 

In a typical yield curve, longer termed instruments have higher interest rates.  This makes sense on an intuitive level: investors demand more interest for locking up their money over longer time periods, in order to compensate them for opportunities missed during that extra time.

A yield curve can change in many ways, but two general changes analysts frequently cite are a flattening yield curve, or a steepening yield curve. 

In a flattening yield curve, the difference between long term yields and short term yields is decreasing.  A flattening yield curve often signals an economic contraction; on a relative basis investors are demanding less of a premium for locking up their money on a longer basis.   

This can be interpreted in two ways: investors aren't optimistic about longer term economic prospects and are happy to earn lesser long term yields, or current economic conditions are such that short term money is at a premium. 

A steepening yield curve is simply the opposite situation. Long term rates are increasing relative to short term rates.  This is also often interpreted in the opposite way as a flattening yield curve; a steepening yield curve may signal an economic expansion.  Investors are demanding more interest to lock up their money long term to compensate them for perceived opportunities lost.

Recently, the US Treasury Yield Curve has been steepening. Again, this makes sense in conjunction with other economic indicators:  employment is increasing, GDP is growing, corporate earnings are climbing, and consumer confidence in our recovery is rising.  Investors are growing more confident in our economy, and as such, are demanding a higher return in exchange for locking up their money longer. 

In addition, the actions and statements of the Federal Reserve have also contributed to the changes in the yield curve.

The Federal Reserve has been suppressing long term interest rates through their bond-buying program.  It has been buying $85 billion a month of interest rate instruments, much of it concentrated on the longer end of the yield curve.  This buying program has served to support long term bond prices; suppressing long term interest rates (remember there is an inverse relationship to a bond's price and its yield). 

Last month, the Fed reduced the amount of their monthly purchases and most experts predict that they will continue to taper the amount of purchases as the economy improves.  As the Fed exits their bond buying program, this removes a large buyer from the markets, and prices should fall in longer termed instruments (and as prices fall, rates rise). 

In addition to the taper of their bond buying, the Federal Reserve has stated that it intends to keep short term interest rates low for the foreseeable future. If that is the case, the short end of the yield curve should not change much, leading to a steepening situation (long term rates increasing and short term rates staying basically unchanged).

Traders interested in trading the yield curve can do it in the futures market through spread trading.  Remember that a steepening or flattening of a yield curve is a change in the difference between short term rates and long term rates. 

M. Krupski
In order to capitalize on a steepening yield curve, traders should buy shorter term instruments (like the 2 year or 5 year note futures) and sell an equivalent amount of longer termed instruments (like the 10 year note or 30 year bond futures). 

Similarly, investors anticipating economic contraction could trade a flattening yield curve by buying futures on longer termed instruments and selling futures on shorter termed instruments.