Bond Yield Curve Holds Predictive Powers

By Barry Nielsen AAA

If you invest in equities, you should keep an eye on the bond market. If you invest in real estate, you should keep an eye on the bond market. If you invest in bonds, you should definitely keep an eye on the bond market! The bond market is a great predictor of future economic activity and future levels of inflation, both of which directly affect the price of everything from stocks and real estate to household items. In this article, we'll discuss short-term versus long-term interest rates, the yield curve and how to use the study of yields to your advantage in making a broad range of investment decisions.

A Primer on Interest Rates and Bond Yields
Interest rates and bond yields are highly correlated, and sometimes the terms are used interchangeably. An interest rate might be thought of as the rate at which money can be borrowed in the form pf a loan and, while most bonds have an interest rate that determines their coupon payments, the true cost of borrowing or investing in bonds is determined by their current yields.

A bond's yield is simply the discount rate that can be used to make the present value of all of a bond's cash flows equal to its price. A bond's price is the sum of the present value of each cash flow that will ever be received from the investment. (To learn more, read Get Acquainted With the Bond Price/Yield Duo.)

Short-Term Versus Long-Term Rates and Yields
When speaking of interest rates (or yields), it is important to understand that there are short-term interest rates, long-term interest rates and any number of points in between. While all interest rates are correlated, they don't always move in step. For example, short-term interest rates might decrease, while long-term interest rates might increase, or vice versa. Understanding the current relationships between long-term and short-term interest rates (and all points in between) will help you make educated investment decisions.

Short-Term Interest Rates
Short-term interest rates worldwide are administered by the nations' central banks. In the United States, the Federal Reserve Board's Open Market Committee (FOMC) sets the federal funds rate, the benchmark for other short-term interest rates. The FOMC raises and lowers the fed funds rate as it sees fit to promote or curtail borrowing activity by businesses and consumers. Borrowing activity has a direct effect on economic activity. If the FOMC finds that economic activity is slowing, it might lower the fed funds rate to increase borrowing and stimulate the economy. However, the FOMC must also be concerned with inflation. If the FOMC holds short-term interest rates too low for too long, it risks igniting inflation by injecting too much money into an economy that is chasing after fewer goods. (For more insight, read Formulating Monetary Policy.)

The FOMC's dual mandate is to promote economic growth through low interest rates while containing inflation; balancing both goals is a difficult task.

Long-Term Interest Rates
While short-term interest rates are administered by central banks, long-term interest rates are determined by market forces. Long-term interest rates are largely a function of the effect the bond market believes current short-term interest rates will have on future levels of inflation. If the bond market believes that the FOMC has set the fed funds rate too low, expectations of future inflation increase, which causes long-term interest rates to increase in order to compensate for the loss of purchasing power associated with the future cash flows of a bond or the principal and interest payments on a loan. On the other hand, if the market believes that the FOMC has set the fed funds rate too high, the opposite happens - long-term interest rates decrease because the market believes future levels of inflation will decrease.

Reading the Yield Curve
The term "yield curve" generally refers to the yields of U.S.Treasury bills, notes and bonds in sequential order from shortest maturity to longest maturity. It is frequently displayed graphically. With the understanding that the shorter the maturity, the more closely we can expect yields to reflect (and move in lock-step with) the fed funds rate, we can look to points farther out on the yield curve for a market consensus of future economic activity and interest rates. Below an example of the yield curve from January 2008. (For related reading, check out Trying To Predict Interest Rates.)

U.S. Treasuries
Bills Maturity Date Discount/Yield Discount/Yield Change
3-Month 04/03/2008 3.12/3.20 0.03/-0.027
6-Month 07/03/2008 3.10/3.21 0.06/-0.074
Notes/Bonds Coupon Maturity Date Current Price/Yield Price/Yield Change
2-Year 3.250 12/31/2009 101-011/2 / 2.70 0-06+/-0.107
5-Year 3.625 12/31/2012 102-04+ /3.15 0-143/4 / 0.100
10-Year 4.250 11/15/2017 103-08 / 3.85 0-111/2/ -0.044
30-Year 5.000 5/15/2037 110-20 / 4.35 0-051/2 / -0.010
Figure 1: Yield Curve January 2008
Source: Bloomberg.com

The slope of the yield curve tells us how the bond market expects short-term interest rates (as a reflection of economic activity and future levels of inflation) to move in the future. This yield curve is "inverted on the short-end" and suggests that short-term interest rates will move lower over the next two years, reflecting an expected slow down in the U.S. economy.

Note: Using the above yield curve as an example, it should not interpreted that the market believes that two years from now the short-term interest rates will be 2.7% (the two-year yield as shown above). While beyond the scope of this article, there are other market tools and contracts that more clearly show a "predicted" future rate of a benchmark like the fed funds rate. The yield curve is best used to make general interest rate forecasts, rather than exact predictions.

Use the Yield Curve to Help Make Top-Down Investment Decisions
Interpreting the slope of the yield curve is a very useful tool in making top-down investment decisions. For example, if you invest in equities, and the yield curve says to expect an economic slowdown over the next couple years, you might consider moving your allocation of equities toward companies that perform relatively well in slow economic times, such as consumer staples. On the other hand, if the yield curve says that interest rates are expected to increase over the next couple of years, an allocation toward cyclical companies such as luxury goods makers or entertainment companies makes sense. (For more on this topic, read Cyclical Vs. Non-Cyclical Stocks.)

If you invest in real estate, you can use the slope of the yield curve to help in your investment decisions. For example, while a slow-down in economic activity might have negative affects on current real estate prices, a dramatic steepening of the yield curve (indicating an expectation of future inflation) might be interpreted to mean future price will increase. Remember, timing is everything! (For further reading, check out Why Housing Market Bubbles Pop.)

You could even use the slope of the yield curve to help you decide if it's time to purchase that new car. If economic activity slows, new car sales are likely to slow and manufactures might increase their rebates or other sales incentives.

Conclusion
Bond market studies shouldn't be left to just the fixed-income investors. The yield curve can help make a wide range of financial decisions. The yield curve reflects the bond market's consensus opinion of future economic activity, levels of inflation and interest rates. It's very difficult to outperform the market, so prudent investors should look to employ valuable tools like the yield curve whenever possible in their decision-making processes.

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