USA:The yield curve and the Economic Time
Summary
A number of articles have reached the press on this vital subject. We discuss the yield curve in the framework of the Economic Clock® and tell you how to make money off this triangle of trouble. (Recently we suggested what to do about the dollar in the context of a steepening yield curve.)
With season's greetings to you from Hong Kong, Enzio
Topics Covered
- Yield curve 101
- The yield curve and the Economic Clock®
- Problems besetting the yield curve
- How to make money off this idea
Background
1. Yield curve 101
The yield curve (YC) tracks the maturities and yields of various debt instruments. These can go from overnight interest rates to yields on 30 year government bonds. So the yield curve is a "map" of interest rates, depending on their maturities. We follow the dollar's yield curve.
The traditional interpretation of the YC is "the steeper, the better": if it is steep, long rates are higher than short rates. This implies that economic activity is about to pick up, so buy the stock market off the back of improved earnings prospects. Obversely, "the more inverted, the worse": if it is inverted, long rates are lower than short rates. This implies that economic activity is about to die, so sell the stock market off the back of worse earnings prospects.l
2. The yield curve and the Economic Clock®
Readers know that whenever there is an excess demand for goods, profits rise and thus stock markets perform well. Traditionally, this is when long rates rise. That leads to a steepening of the YC, particularly when there is an excess supply of money, which implies very low short rates at the short end.
When the Central Bank starts tightening, short rates rise. This results in an excess demand for money. If there is still an excess demand for goods, then profits will keep rising, but less strongly. In this instance, the yield curve has experienced a parallel shift up: both short as well as long rates rise.
Here is a review:
- Yield curve steepens. This is when there is an excess supply of money and an excess demand for goods looms. Thus, long rates rise in anticipation of rising inflation down the track.
- Yield curve "parallels". This is when there is an excess demand for money and an excess demand for goods. Here, the Central Bank has tightened at the short end. So, with rates rising at both ends of the curve, it shifts up in parallel fashion.
3. Problems besetting the yield curve
Were things as simple as we just now have outlined!
The yield curve has steepened - "...to its highest ever." according to the Financial Times' Aline van Duyn in yesterday's edition. But, as she goes on to say, it is steepening because on the short end of the curve, the Fed just last week signalled that its policy would stay frozen for most of 2010. So down went short-term rates: based on the Fed's gloomy outlook, markets do not believe that economic activity and thus profits will rise in 2010.
Meanwhile, as we have pointed out on numerous occasions, the long end of the curve is rising, but not because of the expectation of rising economic activity. Instead, it is rising because the supply of paper is rising. Indeed, in 2011, about three trillion dollars worth of bonds mature and, thus, have to be re-financed. This will not go unnoticed in markets during 2010, i.e. 2011's huge re-financing requirement will be discounted this coming year.
Compounding this fear of 2011's mega-issuances being discounted next year, Gillian Tett (Financial Times, 22nd December) yet again warns of the emergence of G-7 sovereign credit risk rearing its ugly head. This will give rise to more sovereign credit derivatives contracts as well as sovereign credit default swaps. One just hates to think in whose lap all of these risks ultimately will land.... As Dr. Tett notes, "...it is unclear how effective these contracts would really be if a sovereign default did occur, since these deals are typically written by a small pool of interlinked players."
"Thus, the top managers of some large banks are now discussing whether they need to go further - and start making more provisions for different forms of sovereign risk, in the same way that they now make reserves for corporate or emerging market risks. Few banks want to do this, since most are short of capital."
The bottom line: in 2010 we will see a discounting of the three trillion dollars worth of bond issuances hitting markets in 2011, and we will see more banks having to raise more capital in order to make provisions for defaults on their holdings of sovereign bonds...
How to Save/Make Money Off This Idea
- Always consult your financial adviser first.
- Have a look at shorting the U.S. long-dated bond market. I own one such ETF, TBT:US
- Buy the dollar, particularly against the Euro.
