Keeping ahead of the power curve — pa rt three

Wednesday, 4 January 2023 — Albert Park

[7 min read]

Dear Reader,

The yield curve is a remarkably simple construct with predictive properties that are equally remarkable. Constructing a yield curve begins with a graph consisting of a vertical y-axis showing interest rates and a horizontal x-axis showing the maturity of the instruments under consideration.

In today’s low-rate environment, a y-axis that ranges from 0% at the intersection with the x-axis up to 5% at the top of the y-axis works just fine. Of course, in other historical periods, the y-axis would have to go as high as 25% to accommodate the available data. It’s also possible for the y-axis to dip to less than 0% in markets where negative yields to maturity exist as they do in some markets today.

The x-axis begins with zero at the intersection with the y-axis and then progresses through time as you move from left to right. The points on the x-axis might be one month (as is the case of one-month Treasury bills), then two years, five years, seven years, 10 years, 20 years, and 30 years as you move to the right. There are some 100-year bonds out there, but they are rare and thinly traded. The 30-year mark (which is the longest maturity US Treasury bond outstanding) does fine for our purposes.

It’s important to note that there’s no such thing as a generic yield curve. There are as many different yield curves as there are fixed-income markets. The yield curve for the US Treasury market is more or less the layout described above.

There are quite different yield curves for other sovereign bond markets, corporate bonds, junk bonds, municipal bonds, etc. Mixing municipal bond data and Treasury bond data on the same yield curve doesn’t tell us much and muddies the waters in terms of predictive analytic value.

There’s nothing wrong with putting two different yield curves on the same graph in order to make a comparison based on different dates or different markets or to illustrate spreads, but it makes no sense to blend data from disparate markets into a single curve.

It’s also important to note that different scales will be needed for different yield curves. If we’re graphing the US Treasury market as in the curve presented below, a range of -1–4% captures all outstanding maturities. If you were presenting the junk bond market, the y-axis would have to extend as high as 15% to capture yields on most outstanding issues.

The current yield curve for the US Treasury market is presented below. The y-axis (right-hand scale) runs from -1–4%, and the x-axis runs from a one-month Treasury bill to the 30-year Treasury bond. The blue line is the current yield curve, and the red line represents the yield curve one year ago:

The interest rates represented on the right-hand scale are calculated as the yield-to-maturity (YTM) expressed as a percentage return on the instrument based on market prices as of the date of calculation. The YTM is different from the coupon that the note actually pays, which was set at the time it was first sold at auction. That’s because Treasury notes are traded continually in liquid markets. Prices go up or down on a minute-by-minute basis.

Here’s the basic bond maths. Coupons are set on the auction date. As bond prices go up, the YTM goes down and vice versa. So a bond with a par value of $100,000 might pay a coupon of 2.5% when sold at auction. However, if that bond later sells for $101,000, the YTM will drop to less than 2.5% because the buyer only gets $100,000 at maturity.

The $1,000 premium is lost over time. Likewise, if that same bond later sells for $99,000, the YTM rises to more than 2.5% because the buyer picks up an extra $1,000 at maturity. The coupon stays the same, but the YTM goes up or down inversely to the price of the note in secondary market trading.

What this means is that yield curves are shape-shifting. They can steepen, flatten, or even invert (explained below) based on different prices paid for different securities at different times. And that’s where the predictive analytic power of yield curves comes into play.

The shape shifting is not random. It’s the result of real investors making bets with real money. The yield curve is like a snapshot (or even a movie over time) of how investors view the prospects for interest rates and the economy both now and in the future.

The yield curve is the distilled wisdom of all the big money players in the world, from sovereign wealth funds to hedge funds to major banks and institutional investors. Bond investors have a much better track record than stock investors when it comes to seeing the future. And if you want to know what bond investors are thinking, just look at the yield curve. The trick is how to interpret what you see.

Here’s how to interpret the yield curve

The yield curve is what analysts call information rich. This means that the information presented in the yield curve goes far beyond the superficial presentation of maturities and yields. The shape of the yield curve tells you more, and the shape-shifting over time (comparing yield curves created on two different dates) tells you even more.

Particular slopes in different parts of the curve — short term, intermediate term, or long term — are highly revealing as are comparisons of slopes at different maturities and so on. This is how pros look at the yield curve. It’s not difficult; you can easily do it too.

Before jumping into detailed analysis, it’s useful to have a baseline. What’s a normal yield curve? Yield curves are normally upward sloping from left to right. This means that investors demand higher rates at longer maturities. This makes sense.

In a world without inflation, recession, volatility, war, etc., there are no exogenous factors to bend or shape the curve. Investors simply want to get paid for increased risk of unexpected developments at longer maturities. This is called risk premium. So a normal yield curve might show 0.5% at the one-month point, 1.5% at the two-year point, and 2% at the 10-year point. That reflects a normal risk premium and is mildly upward sloping from left to right.

Of course, the world today bears no resemblance to the normal world just described. Inflation, recession, volatility, and war are all front and centre. How the yield curve is shaped by these factors (and, more importantly, what the yield curve tells us about how these factors will evolve) is why yield curve analysis is so valuable.

Keep an eye out next Wednesday for the fourth and final instalment of this series of articles.

All the best,

Jim Rickards,
Strategist, The Daily Reckoning Australia

This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events. Learn more here.

Dear Reader,

We are on our way to France. Checking the maritime forecast, we expected the sea to be so rough. We didn’t want to be seasick for a 17-hour voyage. So we’re taking the short route to Wales, thence across England to the southeast coast, where we will board the Eurotunnel and cross to Calais.

This leaves us little time to read or write. So we begin with a quick market update…and tomorrow…leave you with our memoire of our first Christmas in Ireland.

Here’s the headline from the Financial Times: ‘Markets lose more than $30 trillion in worst year since financial crisis’.

‘The end of cheap money’, begins an editorial.

The BBC adds more bad news:

‘A third of the global economy will be in recession this year, the head of the International Monetary Fund (IMF) has warned.

‘Kristalina Georgieva said 2023 will be “tougher” than last year as the US, EU and China see their economies slow.

‘“Even countries that are not in recession, it would feel like recession for hundreds of millions of people,” she added.’

Caveats and qualifiers

Reading the news, we find many ‘predictions for 2023’. The consensus view is that inflation will relent, the Fed will either ‘pivot’ or at least swing around to less of a ‘tightening’ program...and stocks will end the year higher.

In that regard, a couple of caveats and qualifiers are needed. While US stocks were down about 20% for the year, Turkish stocks rose 110%. What made the Istanbul market suddenly worth twice its value in 2021? A return to the free market by the authorities? New inventions? A booming economy?

None of the above. Instead, an inflation rate of 85% caused Turks to seek shelter in equities. ‘There is a lack of alternatives…’ said a sage in Istanbul.

In other words, stock market gains are not always what they appear to be. Recall that during the late ‘60s and ‘70s, the US stock market held steady…even as inflation erased 75% of the values.

So, rather than guess about the level of the Dow, let’s try to figure out what is really going on.

Readers of these posts will recall, too, that just before the holidays we suggested a couple of provocative, and perhaps seditious, ideas.

First, ‘the government’ is not all of us; it is just some of us. That is always true. And everywhere, true. No matter what you call your government, a small elite always takes control.

When the US was formed, those ‘deciders’ were also outsiders. They made their living by providing goods and services to one another. They understood that government was always a threat to honest commerce. So they attempted to limit it…and to leave ultimate control of the government with ‘The People’ and their representatives.

Leading us to crisis

It was a good try. But after a couple hundred years, the termites have gotten into the woodwork. And the parasites can do pretty much whatever they want. The things that are most ruinous to a country — war and inflation — are entirely under their control. The president can start a war on his own say-so. And the Fed can manipulate the value of the US dollar with no discussion or vote in Congress. Even the First Amendment, guaranteeing Free Speech, has largely been ignored, as federal agents conspire with private companies to restrict what Americans can read.

And now, the deciders are no longer outsiders. Now, they’re insiders. They do not want to limit the power of government, but to extend it further and further. Each step, they realise, brings them more power, money, and status…while diminishing the wealth and independence of their rivals in the private sector.

And the US Constitution is largely irrelevant. The people who wrote the Constitution and the Bill of Rights were completely different from the people who now ignore it.

We have seen, too, that the situation in today’s economy and its markets is almost the exact opposite of what it was 40 years ago. Back then, stocks had been in a bear market for the previous 16 years; prices were low. Bonds had been in a bear market too — dating back to the late ‘40s. As for debt levels, the US Government owed less than US$1 trillion. And the benchmark 10-year US treasury sported a yield of more than 15%.

Today, stocks, bonds, and debt are high, with stocks and bonds nearer to the top of their ranges rather than the bottom…and US debt is at more than US$31 trillion. Interest rates are low (even after the Fed’s hikes, the key lending rate is still about 300 basis points…three percentage points…below the level of consumer price inflation).

Given these circumstances, we have a hunch about where today’s markets are headed…and what the Fed is likely to do about it. In short, we are in a correction. The primary trend is down — for both stocks and bonds. This will lead to a crisis — as it becomes more and more expensive to finance debt.

How the elite will react to this coming crisis is the story of the coming years. Will they tighten their belts and allow the correction to do its work, returning us to a more ‘normal’ financial world? Or will they panic…pivot…and print more money?

We think we know the answer. But we would be happy to be surprised.

Stay tuned.

Regards,

Bill Bonner,
For The Daily Reckoning Australia