Everything You Need to Know About the Yield Curve and its Inversion
June 26, 2018 9:41 am
As a regular market watcher, you have likely heard analysts and policy makers talk about the yield curve and the risks that it has on the markets. They are right to worry. The yield curve is one of the most followed factors by hedge funds, large investment banks, and other policy makers. Therefore, for traders, it is very important to understand the concept of yields and how they impact the markets.
Governments are tasked with providing development to the citizens they serve. To finance these developments, they rely on taxes which they collect from the citizens. These taxes are collected every day. For example, any time you buy a new phone or a plane ticket, the price usually includes a tax. This means that the government is often short of cash it needs to implement the development agenda.
To implement the agenda, the government has several ways to raise money. First, it can go to commercial banks for commercial loans. These are often not recommended because of the high interest rates banks charge. Second, it can go to development agencies like IMF and World Bank for funds. These institutions have caps which means that there is a limit on the amount they can lend. Third, they can go to the money market and issue bonds.
The latter is the most common method governments use to fund their developments. This is because of the unlimited resources found in the private markets. The private market loves government bonds because of their limited chances for a default. The bonds the government issues have numerous maturity periods which ranges from a few months to 30 years.
People who lend the government using bonds receive their full payment at the maturity period. They also receive interest payouts periodically.
Investors pay close attention to the yields on the treasury bonds. While most of them are important, they like paying closer attention to the 2 and ten-year yields. Ordinarily, the yield of the 2 year should be smaller than that of the ten year. This is because, it is easy to predict how a country will be like in the next two years than how it will be like in the next ten years.
The often-quoted yield curve is usually the spread between the ten-year and the two-year yield. The latter is often an indication of where traders believe will be interest rates in the next two years. As mentioned, ordinarily, the two-year should be lower than the ten-year.
When traders say that the yield curve is flattening, it means that the yield spread between the two and ten year is narrowing. If the two-year crosses the ten-year, it means that the yield has inverted. The chart below from Bloomberg shows how the spread between the ten and two-year yields have ben falling since 2010. The recent talk of a trade war have accelerated the drop.
The yield curve matters. This is because in all the 7 past financial recessions have followed an inversion of the curve. If it does invert this year, there is a likelihood that a sell-off in financial markets will happen. This will happen as traders move their money to the bonds because of their high – and secure – yield. Stocks and other assets are known for their volatility and uncertainty.
As a trader, risk management is your most important thing to do as the yield curve inverts. You can do this in two ways. First, always ensure that your trades are tiny. This will ensure that you have comfortable losses in case of a major downturn. Second, you should always ensure that the trades are protected using a stop loss.
As a regular market watcher, you have likely heard analysts and policy makers talk about the yield curve and the risks that it has on the markets. They are right to worry. The yield curve is one of the most followed factors by hedge funds, large investment banks, and other policy makers. Therefore, for traders, it is very important to understand the concept of yields and how they impact the markets.
Governments are tasked with providing development to the citizens they serve. To finance these developments, they rely on taxes which they collect from the citizens. These taxes are collected every day. For example, any time you buy a new phone or a plane ticket, the price usually includes a tax. This means that the government is often short of cash it needs to implement the development agenda.
To implement the agenda, the government has several ways to raise money. First, it can go to commercial banks for commercial loans. These are often not recommended because of the high interest rates banks charge. Second, it can go to development agencies like IMF and World Bank for funds. These institutions have caps which means that there is a limit on the amount they can lend. Third, they can go to the money market and issue bonds.
The latter is the most common method governments use to fund their developments. This is because of the unlimited resources found in the private markets. The private market loves government bonds because of their limited chances for a default. The bonds the government issues have numerous maturity periods which ranges from a few months to 30 years.
People who lend the government using bonds receive their full payment at the maturity period. They also receive interest payouts periodically.
Investors pay close attention to the yields on the treasury bonds. While most of them are important, they like paying closer attention to the 2 and ten-year yields. Ordinarily, the yield of the 2 year should be smaller than that of the ten year. This is because, it is easy to predict how a country will be like in the next two years than how it will be like in the next ten years.
The often-quoted yield curve is usually the spread between the ten-year and the two-year yield. The latter is often an indication of where traders believe will be interest rates in the next two years. As mentioned, ordinarily, the two-year should be lower than the ten-year.
When traders say that the yield curve is flattening, it means that the yield spread between the two and ten year is narrowing. If the two-year crosses the ten-year, it means that the yield has inverted. The chart below from Bloomberg shows how the spread between the ten and two-year yields have ben falling since 2010. The recent talk of a trade war have accelerated the drop.
The yield curve matters. This is because in all the 7 past financial recessions have followed an inversion of the curve. If it does invert this year, there is a likelihood that a sell-off in financial markets will happen. This will happen as traders move their money to the bonds because of their high – and secure – yield. Stocks and other assets are known for their volatility and uncertainty.
As a trader, risk management is your most important thing to do as the yield curve inverts. You can do this in two ways. First, always ensure that your trades are tiny. This will ensure that you have comfortable losses in case of a major downturn. Second, you should always ensure that the trades are protected using a stop loss.
The post Everything You Need to Know About the Yield Curve and its Inversion appeared first on Forex.Info.
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