As a young pup in school, I struggled to get through my mathematical subjects. Oh, I did okay. I didn’t fail, or even require tutoring. I simply didn’t like the subject, so I never gave it my full attention. I guess my brain works more from the right than the left. In any case when I received a question from Edward about the yield curve my first thought was, “Hmmmm … could I explain it and answer the question?” Well, that thought did not last long, Although, studying the yield curve can require some higher mathematics, understanding the basic function and the predictive qualities of the yield curve does not.
I have been trying to unravel the meaning of the yield curve for the present market conditions. American traders are saying the wide spread indicates the market expects growth and inflation. In the UK analysts are saying it means expected rising inflation over the next decade. I understand the inflation side but how can a steep yield curve and inflation equal growth?
The yield curve is the relation between the interest rate (cost of borrowing money) and the time to maturity of the debt. The shape of the yield curve helps give an idea of future interest rate change and economic activity.
Currently, yields on the short-term end are negligible (overbought), and yields on the long-term end are just under 5%. Many economists believe a steep positive curve (which is what it is now) indicates that investors expect strong future economic growth and higher future inflation (cheap money), and a sharply inverted yield curve means investors expect sluggish economic growth and lower inflation (expensive money).
So there you have it. The current yield curve is predicting growth and higher inflation. To understand the growth aspect, you need to understand a simple premise—cheap money invites investment and investment equals growth. Currently, with all the cheap money pumped into the financial system, liquidity is high and as soon as that money begins flowing into the business community (and it will), growth will follow. And when that money flow begins in earnest, money will flow from short-term bonds into equity markets, which will motivate growth. This is what the markets are telling us—it is just a matter of time before growth happens. It is inevitable.
Is it true? Logically, it would appear to be true. Then again, what has been logical about the last two years in the market? Like every other indicator, take this one with a grain of salt. We have never been in this economic position before. What the Fed does, or does not do, this spring will determine the rate of growth and the rate of inflation. The yield curve is simply a reflection of the Fed’s monetary policy and the willingness of investors to invest in the U.S. debt. If you are looking at this market for a trade, keep in mind as the global equity and commodity markets continue the upward trend, those who hold short-term bonds, as well as those who have money on the sidelines, will be attracted to the more risk-oriented trades to get a higher return on their investments.
Trade in the day; invest in your life …
