Tracking Financial Conditions with the Yield Curve

Preview

What is the yield curve, and why does it matter?
What mechanics shape the curve?
How does the yield curve reflect interest rates?
Four primary shapes impact financial conditions.
The easiest way to analyze and diagnose the yield curve.

What's all the hype?

Market participants use the yield curve to observe the changes in interest rates across different timespans. The difference in interest rates across varying timespans forms a curve, revealing where the economy is headed. The shape of the curve provides four leading signals. As the shape of the curve shifts, interest rate expectations shift, impacting the real economy, corporations, investors, consumers, and financial markets. Signals from the yield curve can offer insight to investors, traders, and consumer financial decisions. The four signals

Economic expansion: the future outlook on growth is positive.
Inflation: the future outlook on growth is positive and accompanied by significant price rises.
Economic uncertainty: The future outlook on growth is uncertain and possibly recessionary.
Recession: The future outlook on growth is consistently negative.

The 4 shapes

The shape of the yield curve directly influences financial conditions.

Normal = Economic expansion
Steep = Inflation
Flat = Uncertainty
Inverted = Recession

The Mechanics

The yield curve can be confusing because it reflects the interest rates, bond yields, and the demand for bonds all at the same time. So first, you want to understand the relationship between bonds and bond yields.

Each bond has a price, and each price is tied to a yield. The price of the bond and its yield are inversely correlated 🔀, meaning they move in opposite directions ⏫⏬. The more demand there is for a single maturity, the higher the price moves and vice versa

If the price of a bond goes up ⤴️, the yield of that bond goes down⤵️.
If the price of a bond goes down ⤵️, the yield of that bond goes up⤴️.

Over time, the demand for bonds moves the price of the bond as well as the bond yield.
Because U.S bonds, also known as U.S Treasuries, are considered the most pristine collateral, the bond yield is universally accepted to set interest rates. Thus, the change in yields equals the change in rates. Back to the Yield Curve...The yield curve tracks bond yields/interest rates ranging from 1 month to 30 years.

Short duration / T-Notes	Mid duration / T-Bills	Long duration / Bonds
1 month 2 month 3 month 6 month 1 year	2 year 3 year 5 year 7 year 10 year	20 year 30 year

Each yield is spread across an X and Y axis.

The X-axis represents the time to bond maturity (duration).
The Y-axis represents the total yield each bond produces if it reaches maturity.

Forming the shape of the curve

Connect bond maturities from 1-month to 30-years to get the shape of the curve.

Here's what the entire yield curve looks like as of April 2022

Find the current yield curve here.

The Interest Rate Effect

Lenders use treasury bond yields to set their interest rates.

Who are lenders?🏦

Commercial banks
Investment banks

Who's borrowing? 💰

Consumers borrow for mortgages, vehicles, equipment, etc.
Corporations borrow to support business growth.
Investors borrow to capitalize on markets.
Banks borrow to maintain credit lines and cash reserves.

How does the yield curve come into play? Interest rate fluctuations are tied to fluctuations in bond yields. If bond yields are tracked across the yield curve, then the yield curve is reflecting interest rate fluctuations for different lengths of time.

When interest rates fall (bond yields), the demand for borrowing increases and vice versa.
Borrowers can observe the curve to evaluate the optimal timeframe to borrow.

Borrowing at the short end...An upward-sloping yield curve reflects lower interest rates at the short end of the curve. It also reflects a shift in demand from long-duration treasuries to short-duration treasuries.

For a small business or corporation, borrowing a 12-month loan may be more attractive than a 30-year loan because the cost to borrow is cheaper.
Overnight bank-to-bank lending increases as it gets cheaper to borrow short-term capital.

Borrowing at the long end...A downward-sloping yield curve reflects lower interest rates at the long end of the curve. It also reflects the demand shift from short-duration treasuries to long-duration treasuries.

A small business or corporation may find it cost-effective to borrow long-term debt to fund long-term growth.
A homebuyer or car buyer may find it cost-effective to sign the longest-duration mortgage because rates are cheaper.
A home-owner or car owner may want to refinance, extending their loan for a cheaper rate.
When short-term rates are expensive, short-term lending/borrowing activity drys up.

Fixed vs. Variable RatesBorrowers with an existing fixed rate will not be affected by changes in bond yields unless they are looking to refinance. However, borrowers with a variable interest rate are subject to changes within the yield curve.

Variable rates carry more risk but can be more rewarding in the right conditions.
Fixed rates are less risky because borrowers can always refinance if bond yields fall.

Financial Conditions

Markets are exceptionally sensitive to rate changes because most market participants are leveraged with debt. Small changes in rates can make or break these leveraged players causing extreme fluctuations in stocks, bonds, real estate, and crypto. When debt servicing costs rise, it eats away at earnings hurting revenue projections and sentiment. Stocks get riskier, and eventually, stocks sell off. Unemployment rises, productivity falls, and weaker than expected economic conditions feed into recession fears. The opposite scenario happens when the costs to borrow & debt servicing costs drop.

The normal yield curve

points to economic expansion

Financial conditionsA healthy curve slopes up over time, suggesting conditions are expected to improve. The flattening at the end of the curve suggests growth will not ignite inflation. When rates are lower at the short end, lending/borrowing increases to stimulate business activity, which stimulates growth.InvestorsIn a healthy economy, treasury demand shifts towards the short side, enabling an economic expansion. As the economy expands, investors can shift their capital towards higher-risk, higher-reward investments such as stocks, commodities, and other risk assets that outperform less risky investments such as treasury bonds.
Impact on EquitiesWhen rates are lower at the short end of the curve, it eases companies borrowing costs and debt burdens. Overall, lower rates improve profit margins.

The steepening yield curve

points to economic expansion accompanied by inflation

Financial conditionsA steepening curve suggests significant inflation is expected to accompany growth. The further you go out on the curve, the more bond yields price in inflation by rising. Inflation not only eats away at buying power and future returns but hurts lending/borrowing demand through higher rates. This negatively impacts consumers, businesses, and the overall economy. Investors
Long-duration treasury bonds sell off because inflation expectations have made them riskier, illustrated by the rise in yields. Investments that rely on long-term rates to remain low are punished as the cost to borrow and service debt increases. If investors can identify where the inflation is coming from, they can capitalize on it by making investments that benefit during inflationary environments (typically commodities).
Equity impactsCompanies holding long-duration treasuries as cash equivalents become sensitive as their cash reserves suffer from a drop in the bond price. Companies servicing long-term debt or dependent on long-term borrowing also become sensitive as long-term interest rates rise.

The flat yield curve

points to uncertainty

Financial Conditions...A flattening yield curve signals uncertainty in future expectations. Conditions can shift either way. Economic data, policy, and sentiment begin to drive price action. This could be a suitable environment for short-term traders because volatility increases.From flat to normal

The curve is moving into economic certainty and relief.

There's a shift away from the safety of long-duration bonds and into high-growth investments with more risk and reward.
Short-term rates fall, which helps stimulate growth through lending and borrowing activities.
Sentiment improves for companies whose operations depend heavily on short-term rates.

Flat to inversion

The curve is moving into economic distress.

As short-term rates rise and borrowing drops, growth slows, and investors seek protection in long-duration treasuries that offer fixed income.
Companies dependent on short-term rates suffer from rising costs.
Companies holding short-term treasuries as cash also suffer as their reserves contract.

The inverted yield curve

points to recessionary conditions

Financial ConditionsA downward sloping curve suggests a significant cut in growth expectations, sometimes to the point of recession. Higher rates turn off borrowers, and banks become skeptical of lending to shaky businesses. While short-term rates are elevated, economic activity slows down due to the increase in short rates slowing down lending.InvestorsInversion reflects an influx of treasury bond demand at the long end of the curve, where investors can feel the safety of long-duration risk-free fixed income. Short-duration bonds have become riskier, illustrated by much higher rates and a lack of near-term growth. Riskier investments that depend on short-term rates suffer, while less risky investments that benefit from better long-term rates become more attractive.EquitiesCompanies that depend on short-term lending to pay off short-term expenses suffer from higher rates. Companies that hold short-term treasuries as cash equivalents see a drop in cash reserves. Companies can benefit in this environment if they hold long-term treasuries as cash equivalents because their cash reserves have increased. If they have long-term debt, then their servicing costs would decrease.

The best recession indicator

The 10y/2y spreadThe 10y/2y spread predicted the last six recessions:

1980
1981-82
The early 90s recession
The infamous dot-com bubble
The 2008 Global Financial Crises,
The 2020 C-19 recession.

Investors and analysts will use the 10y/2y spread because it's shown reliability and simplicity in predicting a recession.

How to use 10y/2y spread

First, anything touching the zero bound is considered a flattening curve, aka uncertainty. At 0, 10y and 2y rates are the same.
Below 0 is considered inverted, suggesting a recession will come in the next 6-18 months. For example, a -30 means the 2y rate is 30bps higher than the 10y rate.
Third, track other macro indicators to narrow down the beginning or end of a recession.
4th, you will never time it perfectly, have a plan.

So far, the 10y/2y has been very accurate. Keep this in your toolbox. Add it to your trading view watchlist: T10Y2Y

Key takeaways