This article was written by me, Brian Twomey in 2009, thought reader interest today
Yield curves can have dramatic effects on the US overall.
|With nations struggling with recessions, low interest rates, and corporate bailouts, maybe it’s time to step back and review not just the individual markets but look at the bigger economic picture through interest rates, yield curves, LIBOR, and Fed funds rates as an indication of where we were and where we may be heading. Through this analysis, you may be able to determine where and when the next cycle will occur so traders will have a better understanding of their individual markets and a broader economic picture.To do so, there is no better way than the old reliable yield curve that has predicted economic boom and bust cycles for many years. In this article I will highlight the definition and purpose of yield curves as a predictor of booms and busts. I will also analyze the LIBOR and fed funds rates, as interest rates are not only the driver of markets but a determinant of economic activity, both past and future.
THE YIELD CURVE
In the historical sense, the yield curve has four unique shapes: flat, inverted, humped, and rising slope. A rising slope curve simply means interest rates are aligned and properly ordered, where short-term rates offer low interest based on the present interest rate outlook and longer-term bonds offer higher interest rates. All maturities fall within a system of expected economic growth.
An inverted yield curve is quite the opposite. Here, short-term rates yield more than longer-term rates. The long end of the curve comes down. This presages an economic downturn and a fall in interest rates as evinced by investors not willing to risk capital for longer terms. This is an environment not conducive for bank lending, as the “borrow short” and “lend long” scenarios cannot result in profitability. This is the first sign of a downturn and possibly the end of a booming economic cycle.
|A flat yield curve occurs when yields of shorter-term T-bills and longer-term bonds yield the same. This is evinced by a straight line on a chart. This scenario reflects an impending economic downturn as confidence in the economy is waning. Flat yield curves may also be derived from previous interest rate reductions.A humped yield curve occurs when short- and long-term yields are equal and medium-term yields are higher than the longer- and shorter-term yields. This scenario would highlight great uncertainty both in the marketplace and in the overall economy. A humped yield curve could be caused by shocks to the economic system such as an asset bubble burst, the recent housing crisis, or any event that has an air of crisis attached to it. Shocks cause yield curves to rise, influencing interest rates on all maturities. This in turn affects the slope of the curve because short-term yields rise faster than longer-term yields. The slope is not the healthy and perfectly ordered upslope where short-term yields and longer-term yields look like a perfect trendline. Instead, a hump in the line takes shape due to the influence of medium-term yields.
To further understand yield curves and the progression of understanding of the causes and effects that influence the lines and slopes associated with the curve, a brief review of the historical research would be apt here.
That was the hypothesis that a tradeoff existed between unemployment and inflation. Low employment means a higher increase in wages. What came from this research was a better understanding of economic activity and improved forecasting methods within the 12 Federal Reserve districts as mentioned every month in the economic releases by the 12 Federal Reserve Board districts. They now measure accurate manufacturing activity. The yield-only model understood yield curves in terms of yield spreads. By subtracting the 10 years from the lower time frame spreads and finding a negative number anywhere along the curve, recession is predicted four quarters or so in the future.
A positive number denotes a healthy economy. Today, however, the difference between the three-month T-bill and the 30-year long bond should have about a three-point spread to denote a healthy economy. The modern-day understanding of the yield curve and its predictive power comes not from spreads, but short-term rates. This can be addressed first through the Fed funds rate.
|THE FED FUNDS RATE
The Fed funds rate is the rate controlled by the Federal Reserve. It is short term in nature and controlled by a vote of the Federal Reserve Board eight times a year and managed by the buying and selling of bonds, notes, and bills. This is the rate that banks charge each other for overnight loans. These are the cash rates, or the liquid rates. Because these rates are so short term, all other maturities are influenced along the yield curve.This rate influences the cost of borrowing between people, companies, and governments. A healthy borrowing atmosphere is a sign of a healthy economy because it denotes expansion. To better understand the Fed funds rate, yield curves, and business activity, you must understand Fed funds futures and implied volatilities.
To understand implied probabilities, let’s take a brief walk through history. The Fed controls monetary policy by raising or lowering the prime rate where the Fed funds rate was left to the devices of the market. By 1995, a change occurred in Fed policy where the Fed announced an explicit target for the Fed funds rate to better regulate the supply of money.
This changed economic dialogue. The nominal rate is now the target rate, whereas the overnight lending rate is the effective rate. The overnight rate is important because banks must assure they have the required reserves in their holdings by law. Since November 2008, the Fed now pays interest on reserves of 1% to prevent the Fed funds rate to not slip and trade to zero since today’s rate is 0.25. Perhaps this is the reason for the Fed to change yet again another policy where they now announce a range of their effective rates.
This created a tradable market but was later used as a means to predict the direction of interest rates because of the difference between the target and effective rate. What also helped was the change in Fed policy where they would announce their interest rate changes directly after the two-day meeting and not wait until the next day, as was once the practice.
FED FUNDS FUTURES
For example, assume the Fed funds target rate is 1%. The next meeting is December 10 and you expected an increase of 0.25 to 1.25. Basing the usual contracts over a one-month period, the calculations work like this:
----------------------- 10 (number of days in the month until the next meeting) x 1.00 (rate) + 20 (number of days left in the month) x 1.25 (expected rate/31 days left in the month) = 0.16 A December fed funds contract priced at 98.99 for an implied yield of 1.01. So (1.01 - 1.0) (1.16 - 1.0) = 0.16 ------------------------
So the probability that the Fed will raise rates from 1.0 to 1.25 is 0.16, which is very low. With investors and traders not having much faith in the future upward direction of interest rates, using this example, the short end of the yield curve can only have a downsloping direction. So traders trade the short curve, where their trades are votes on the direction of the money supply.
|Another way to look at the short end of the yield curve and a further reason why this end is the most important is to look at a widely traded instrument called the forward contract. Interest rate structures refer to a graph of forward contracts. Within this structure are strip yields vs. maturity of strips. This is called the spot yield curve and just another way to build your own yield curve.Strip rates refer to spot rates. Strips are the yield to maturity plotted on a graph of zero coupon bonds. These are again another way to predict the direction of interest rates. Expectations theory says these rates will prevail in the future. This may be one determinant, but the correlation is not 100%.
There are many other methods to look at short rates through trading instruments to determine the short end of the yield curve. These include credit curves, interest rate swap curves, swap curves, and even the possibility of understanding the yield curve from a longer-term perspective. The Treasury now issues 30-year bonds. A curve can be analyzed from these “on the run” instruments through the long end.
If short rates are coming down according to implied probabilities, what does this say for a trade on the 30-year bond? Another way to look at interest rates and further understand the yield curve is through LIBOR rates.
THE BIG PICTURE
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