The Treasury yield curve is one of the best and most
useful tools that a global macro investor can have in
his or her toolbox. Normally used for bond trading,
there are several applications for it in the stocks and
currency market as well. The truth is by using the yield
curve correctly you can better trade just about everything.|
The Treasury yield curve is the curve you get when you plot out the yields for different maturities. For instance if the 90-day T-Bill is at .2 percent and the 10-year T-Note is yielding 3.5 percent you have an up sloping yield curve as the long dated Treasuries are paying a higher yield then the short dated Treasuries. Usually you would also plot out the two year, five year, and thirty year along with the ninety day and ten year. This will give you a better picture for what the yield curve is really saying.
So how do you apply the yield curve to your trading? Well there are a few main rules of thumb. An upwards sloping yield curve is typically bullish for the economy and stocks, whereas a downwards sloping or inverted yield curve is typically bullish for bonds.
You may be asking yourself why this is. The reasons are actually fairly simple and straightforward. If the curve is steep, meaning the short term rates are low and the long term rates are high, it means that banks are lending as they are able to borrow short term from the Fed and charge long term rates to their customers. Obviously, when business is good for the banks, they will be lending as much as they can. This, in turn, spurs new business spending as money is available.
If the curve is inverted however business is usually about to slow down, rates will be lowered, and bonds will climb. This is because with the incentive of the banks to lend now gone they will throttle back and the spigots of available money run dry. In turn this forces the Fed to lower short term rates, the Fed Fund rate, in order to spur business growth once again. When they lower rates bonds inevitably go up.
Bonds and rates are like a piece of wood straddled on a log. If you sit at one end the other end goes up. If bonds are at one end yields are at the other. When yields go down bonds go up and vice versa. This is almost always the case, especially in an inflation environment.
So anytime that you see either of these events happen the global macro investor can start to look for an entry point to either buy or to sell bonds and stocks. If the curve is inverted then you will likely want to start buying bonds and selling stocks as the act of lowering rates will cause bonds to go up. After bonds have gone up and it looks like the Fed is done lowering rates it is worthwhile to look at stocks as the next beneficiary of the rate cuts as businesses can now borrow cheaper and therefore expand faster.
Of course as with all things in the market nothing works every time. In fact, the quote history never repeats itself, but it often rhymes is a very appropriate statement. Used along with proper risk controls the yield curve can become one of the global macro investors best timing tools and economic gauges.
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