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What is the yield curve telling us?

The market is telling us that the Federal Reserve is doing a poor job of assuring investors that inflation is under control.

I am sure many of us understand that a yield curve is simply the term structure for a particular debt instrument. In other words, it plots the interest rate associated with different contract lengths on a graph. However, it can become quite confusing when trying to understand all the intricacies of what the yield curve is telling you.

Today, I will simplistically walk through the basic dynamics of the yield curve with reference to the US Treasury curve (chart below) considering it is undoubtedly the most important curve globally.

Before diving in, it is worthwhile noting that the short end of the yield curve is predominantly affected by the expected Federal Reserve (Fed) policy changes, whereas the long end of the curve is influenced more by the outlook for economic growth and inflation expectations. It is important to keep this in mind as it will assist in understanding why the yield curve is changing.

Okay, let’s start off by describing what the four main states of the yield curve are and what they mean:

  • Bull Flattener = Falling interest rates and a flattening yield curve. This means that long term rates are falling faster than short term rates.
  • Bull Steepener = Falling interest rates and a steepening curve. This means that long term rates are falling slower than short term rates.
  • Bear Flattener = Rising interest rates and a flattening yield curve. This means that long term rates are rising slower than short term rates.
  • Bear Steepener = Rising interest rates and a steepening yield curve. This means that long term rates are rising faster than short term rates.

When breaking down the above jargon simplistically you can say that in terms of price, bull means that interest rates are falling, and bear means that interest rates are rising. It next describes the shape of the yield curve as either steepening or flattening. When combined, each of these states gives indications about the type of economic environment we are in and what investors can expect.

By looking at the chart below, you can see that the spread between the 2- and 10-year yields, which is used as a representation for the shape of the yield curve, inverted or turned negative for a brief period in April. Many see an inverted yield curve as a predictor of an economic recession because it suggests that the market’s long-term outlook is poor, and as a result, long-term yields fall.

Yield curve inversions have preceded every recession since 1955 with just one false signal in that period and thus have become known worldwide. I am sure most of us have already seen countless headlines about the yield curve inversion and thus I will not dive deep into this topic today. I will rather focus on what the yield curve has done since inverting.

As you can see, the curve has been steepening whilst we are in a rising rate environment. Thus, based on the above definitions, it can be concluded that we are currently in a bear steepening environment.

The big question is what does this actually mean?

I would argue that given the current environment of rising inflation, rising interest rates and slowing growth; the market is telling us that the Federal Reserve is doing a poor job of assuring investors that inflation is under control and thus the market remains wary and uncertain. The fact that the long end of the curve is rising faster than the short end also implies that the market believes the Fed is not being hawkish enough to bring down inflation and ultimately expectations regarding future inflation.

Consequently, I believe that we can expect the elevated volatility to remain in markets for the time being with a bias towards downside movements in risk assets.

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Disclosures

Global & Local Investment Advisors (Pty) Ltd is a registered financial services provider in terms of the Financial Advisors and Intermediary Services Act (FAIS). Global & Local Investment Advisors (Pty) Ltd holds FSP license number 43286.

Global & Local Asset Management (Pty) Ltd. Reg. Number: 2018/580284/07

Global & Local Asset Management is an authorised juristic representative of Global & Local Investment Advisors (PTY) Ltd FSCA License Number: 43286

Any investment performance figures quoted herein are for illustrative purposes only and should not be construed as investment advice.

Investment advice can be provided by Global & local Investment Advisors (Pty) Ltd but only after an analysis has been conducted of the investor’s current financial circumstances and investment portfolio, only then will a recommendation be provided based on that investor’s own circumstances by Global & Local Investment Advisors (Pty) Ltd.

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Investment advice is offered through New Age Alpha Advisors, LLC a wholly-owned subsidiary of New Age Alpha LLC.

New Age Alpha Advisors is an investment advisor registered with the U.S. Securities and Exchange Commission. New Age Alpha Advisors, located in the State of New York, only transacts business in those states in which it is properly registered or qualifies for an applicable exemption or exclusion from such state’s registration requirements.

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Mauro Forlin

Global & Local Asset Management

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