Reading US Treasury Yields and Curves in the 21st Century
Traditional Thinking – Yield Curve Flattening portends Recessions
The flattening of the yield curve in November and December 2018 has brought out every Fixed Income research analyst and quotable portfolio manager, who continue to write in newspapers and white papers, and give warnings on TV about the impending recession that the yield curve is signaling, based on their analyses of history.
From this NY Times article: “Every recession of the past 60 years has been preceded by an inverted yield curve, according to research from the San Francisco Fed. Curve inversions have “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession,” the bank’s researchers wrote in March.”
Traditional Thinking – TIPs Breakevens portends Inflation
The standard and tradition process to gauge Inflation expectations is from ‘TIPS Breakeven Rates’ – Nominal UST yield – TIPs yield of the same maturity. Quoting the Fed via Bloomberg’s analyst, Ira Jersey, in a 2/12/19 article
“The lack of trading volume in TIPS is one of the reasons the Federal Reserve tends to cite in explaining why TIPS breakevens are one — but not necessarily the only or best — indicator of how the market views inflation.”
Both these measures are rather simplistic, and do not account for the global nature of money, capital flows, and investors. The structure of the markets has changed relatively recently, since the mid-1990s, and Fixed Income, Finance, Economics and Macro education has not kept up. International flows were minuscule, until Japan’s “Big Bang” in 1996 exposed international markets to gigantic flows of capital, reversed the workings of macro-economic policy, and distorted money supplies.
Modern Toolkit required to interpret a US Treasury bond or bill yield movement
- US Treasury Yields
- TIPs or TII (Treasury Inflation Protected/Treasury Inflation Indexed bonds) Yields
- 0yr-2yr, 2yr-5yr, 2yr-10yr, 2yr-30yr and 10yr-30yr yield curve spreads/slopes
Modern, in addition to the above
- T-Bill and Note/Bond supply
- Central bank holdings and purchases of USTs
- US Interest Rate Swap spreads
- Yen currency rate Y/$
- S&P 500 Index
Readers of our Crisis Notes and other Macro analysis will be aware of the remaining tools required to complete the analysis of Asset Prices. These have been extensively analyzed previously in The Failure of Macroeconomics, so will not be described in detail here. They are:
- Policy Interest Rate Differentials between Japan, China, ECB and US Fed Funds
- Issuance of foreign currency denominated US bonds, primarily Samurai bonds
Some definitions – TED spreads and Swap spreads
TED: Treasury (bill futures prices) over Eurodollar (futures prices). However, it is usually quoted in the difference in discount rate implied by the futures prices, and called the TED spread. Eurodollar rates are the short end of the LIBOR curve. The TED spread is thus interest rate spread of LIBOR over US Treasury yields/rates typically under 1 year maturity.
Swaps: Interest rate swaps are contracts to exchange a fixed rate for a floating rate. The fixed side is usually quoted as a spread over US Treasury yields of the same maturity, has a fixed payment, and mimics a bond. The floating side is usually 1-mo or 3-mo LIBOR. The fixed side is thus term-LIBOR of longer and different maturities, and is (or was) a benchmark for bond valuations of different maturities, reflecting yields for credit risk. Because swaps form the 1+ year part of the LIBOR curve, movements in TED spreads flow through into swap spreads. By buying a swap, one is long a synthetic fully levered bond, funded with LIBOR (spoiler alert: LTCM’s downfall); by shorting a swap, one can hedge a long position in a bond.
The table below is copied from my 1988 Merrill Lynch booklet An Analytical Guide to Interest Rate Futures Spreads, and summarizes the factors that impact the TED spread (and thus Swap spreads) that I identified at the time.
Factors Affecting The TED Spread
(continued)MBS Reading T-Leaves Opt