Yield Curves

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
The yield curve measures the difference of interest rates between shorter-term three-month US Treasury bills, medium-term US 10-year notes and newly issued longer-term US 30-year bonds. This is the beginning of prices for fixed-income securities. The prices of these various maturities and trader preferences for yield and length of time they are willing to hold an asset are what form the curve. It is an outgrowth of the markets drawn strictly from the invisible hand, to more or less quote the economist Adam Smith. This is what also gives the yield curve its predictive economic nature.

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 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.

LOOKING BACK
Historical research less than 20 years old focused on the yield-only model and failed to incorporate or even understand the macroeconomic factors that could influence the curve. How the yield curve correlates to business cycles was a hot research topic 15 to 20 years ago. Introduction To Econometrics, the work by James Stock and Mark Watson, gave relevance to the old Phillips curve as a way to control business cycles. Other factors were considered, but the Phillips curve was high on the agenda.

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.

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
The Chicago Board Options Exchange (CBOE) began trading put and call options on Fed funds futures in 1988. These are referred to as implied volatilities and can be one of the best predictors of the direction of interest rates. Banks that wish for rates to stay the same or hedge an interest rate direction, speculators, and traders are all involved in this trillion-dollar market.

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.

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.

LIBOR
LIBOR is the one that banks charge each other for overnight loans. This rate is published by the British Bankers Association. This rate is released about 5:00 am Eastern time. LIBOR is an average of measured interest rates. It is not a tradable rate, yet this is where rates begin any trading day in London and are negotiated throughout the day by borrowers. LIBOR is also calculated based on 10 currencies: Australian dollar, New Zealand dollar, British pound, Canadian dollar, Swiss franc, Swedish krona, Danish krone, euro, yen, and the US dollar. The US dollar plays a role through the LIBOR and OIS spreads. OIS is the overnight indexed swaps. These swaps are a measure of available cash for interbank lending and determine interest rates for banks. When cash is not available to lend, the spreads increase. Rates have increased lately because LIBOR is trading well above the prime rate. You can't borrow short and lend long because bankers and lenders can't make a profit. Because mortgages are so closely tied to these LIBOR--US dollar rates, consumers can't expect to find loans readily available.

THE BIG PICTURE
Yield curves in the United States are a product of vagaries of US economic conditions. Yet the economic interdependence that we share with the rest of the world through our markets can have dramatic effects on our yield curve. Newly traded instruments over the last 20 years that have more of a short-term nature can have serious ramifications for understanding the yield curve fully from the short end to the longer term. The focus is always on the short term as this presages implications for future economic activity and interest rates.