Breaking Down the Yield Curve

The Treasury yield curve is one of the more important animals in finance. It tells us how much each Treasury bill, note or bond yields across the maturity spectrum.

For the most part, a steep yield curve is bullish for the economy and stock market. A flat or inverted yield curve has often preceded rough times. The yield curve is one of the few forward indicators that has a good track record of predicting what will come.

The yield curve also gives us a glimpse into the future. For example, if we look at the yields on the one- and two-year Treasury, we can work out the math to see what the market believes a one-year Treasury will yield one year from today.

Warning, math ahead. The one-year currently yields 0.14% and the two-year goes for 0.47%. So if you were to get a yield of 0.14% for the next year, you would need to yield 0.80% for the following year to make a two-year yield of 0.47%. Think of it as the market’s opinion for what the market will say in the future.

Here’s the interesting part—every yield curve has in it an implied direction for short-term interest rates. The exact same information in any yield curve can be expressed in the expected direction of short-term rates. For example, we can take the two-year Treasury and compare it with the two-and-a-quarter-year Treasury, and see where the market thinks three-month bills will be two years from now. The steeper the curve, the more rapidly rates are expected to rise.

Check out the chart I made below. The red dots are the current Treasuries at yesterday’s close. I added the blue line in an attempt to smooth out the trend of the red dots. The black line is the implied three-month T-bill based off the blue line.

I have to add that the black line looks a little screwy after about five years out. Don’t worry about that part of the graph. The problem is that any small deviation in those long-dated bonds can have a big impact on the implied short-term rate.

The interesting part is what’s expected over the next five years. The bond market’s view is largely inline with the Fed’s most recent guidance. In fact, the bond market is a bit more hawkish than the Fed. The bond market sees rates rising next year and hitting 1% before the year is out. After that, rates are expected to rise continually until the middle of 2017 when they’ll be near 3%.

Janet Yellen’s comments last week caused that rise in the black line, from 0% to 3%, to move to the left by two months.

(My pal, David Merkel, has made these types of graphs before, I believe, with a smoothing function.)

Posted by Eddy Elfenbein on March 25th, 2014 at 8:34 am

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