The Yield Curve Explained – Introduction
As a trader, you have most definitely heard commentators talk about the yield curve. It is one of the most common terms in the market this year as the market conditions change. This article will explain more about the yield curve and why it matters to traders. While all countries contain yield curves, the most common curve is the one from the United States.
The yield curve starts from the bond market. A bond is the amount of money that individuals and investors give to companies, municipals, and governments. To these entities, a bond is the cheapest and easiest way to raise money. The United States is the biggest issuer of bonds, which the country uses to fund development.
In a bond, you fund these entities and then receive interest at certain periods. You will then receive the principal amount when the bond matures. In a normal situation, shorter-term bonds attract lower interest because the short duration is more certain. The longer-dated bonds attract a higher interest rate because investors need a higher return for tying up the money for longer periods of time. Therefore, when the shorter term and longer-term bonds are plotted, the chart moves from low to high.
When there is the inversion of the yield curve, the opposite happens. This is when the shorter-term treasuries yield higher returns than longer-term treasuries. The yield curve is simply the spread of the longer-term bonds and shorter-term bonds. The most common periods are ten years and two years. The chart below shows the continued narrowing of this spread.
When the economy is doing well, investors tend to get concerned about inflation and higher interest rates. Therefore, they require more yields from longer-term bonds. When the Federal Reserve raises rates, the short-term yields rise in relative to the long-term yields as inflation expectations rise. The problem comes when the Fed tightens very fast and causes the short-term rates to rise above the long-term yields.
The worry among investors is that all the seven past recessions came at a time when the yield curve had inverted. That is, when it moves below the zero line. Therefore, since it is always difficult to predict when a recession will take place, investors use data such as this to predict when it will happen.
However, there are a few things you need to know. First, not all yield curve inversions have lead to a recession in the past. Second, when it happens, there is usually a lag time between the inversion and the recession. In the past, it takes between 6 months and 2 and a half years for a recession to lead to an inversion. Third, the predictive power of the slope has not always been an effective yield curve indicator. Fourth, the yield curve inversion does not lead to a recession. Instead, an inverted yield curve worries investors because it tells them the expectations about the economy. Finally, the yield curve is one of the many market factors that could point to a recession. The others include the jobless claims, consumer spending and capital investments among others.
Therefore, with risks rising, as a trader, you need to always be prepared about what to expect. In this, you should always do your best to protect your trades using a stop loss, position your trades well, and reduce the chances of leaving open trades in overnight trading.