A time to reconsider the bond market.
The President-elect’s designate for the position of Treasury Secretary is not a former leader of Humongous Bank & Broker (HB&B), but he is an expert on bonds. Ergo: one thumb up. His first remarks about extending bond maturities to 50 to maybe 100 years is bound to have a very positive impact on the economy, and reflects his choice as Treasury Secretary as being a very good one. Ergo: two thumbs up.
The steepening yield curve that will develop will finally bring trillions of dollars from the sidelines into play. Where that capital will go is along the lines of what I have been writing, and the market has been anticipating since shortly before Trump’s election. It will go into oil and gas exploration, homeland security programs and expenditures on roads, bridges and waterways. Yes, trillions. All because the new Treasury Secretary designate had the guts to say he wants to extend the long bond maturities.
How important is that might be gleaned from a re-read of a part-chapter of my 2007 book, which I am re-publishing below.
Lessons from the Trader Wizard, 2007, Bill Cara
The yield curve (pp 71-75)
(written August 2007)
I cannot leave the section on bonds without addressing the yield curve.
Inexperienced traders have two misconceptions about the bond market:
(1) they presume interest rates are the same as bond yields, which are,
in fact, not the same; and
(2) they think the bond market goes up and down with all yields moving
together. Everybody, however, should know that yields of different
bond maturities behave, to some extent, independently of each
other. In fact, short-term rates and long-term rates occasionally
even move in the opposite direction.It is very important to understand the yield curve and to keep monitoring
it.The yield curve is a line chart that, at any given time, shows yields for all
securities having equal risk, but different maturity dates. It is used to
compare a government’s short-term Treasury bills with its mid-term notes
and long-term bonds. The line begins on the left with the yield of the
shortest maturity and ends on the right with the yield of the longest
maturity. The next day, as the different yields change to a different extent,
the line between the various yields will shift.What’s important is the overall pattern of yield movement — and what it
says about the future of the economy and the capital markets. The yield
curve is an important tool for economists, but it should also be one you
use as well. It’s probably the most important concept inexperienced traders
could learn and apply.In a healthy economy, income securities with longer maturities usually
have a higher yield. This is the normal yield curve, which is sometimes
called a positive yield curve.If short-term securities offer a higher yield, then the curve is referred to
as an inverted yield curve or a negative yield curve. This doesn’t happen
often, but when it does, it’s a clear sign that bond yields, as well as interest
rates in the general economy, are expected to decline.At times the yield curve will go fairly flat.
Ordinarily, short-term bonds carry lower yields to reflect the fact that a
trader’s capital is subject to less risk. The longer you tie up your cash, the
theory goes, the more you should be rewarded for the risk you are taking.Who knows, in fact, what’s going to happen over three decades that may
affect the value of a 30-year bond?A normal yield curve based on a stable and growing economy, therefore,
slopes gently upward as maturities lengthen and yields rise. From time to
time, however, the curve changes into a few recognizable patterns, each
of which signals an important turning point in the economy. When those
patterns appear, it’s often wise to change your assumptions about economic
growth.When bond traders expect the economy to move at slower rates of growth
with possible negative changes in inflation rates or available capital (ie,
liquidity), the yield curve slopes downward.To help you learn to predict economic activity by using the yield curve, I
have isolated four of these shapes — normal, steep, inverted and flat — so
that I can demonstrate what each shape says about economic growth and
stock market performance. This data was derived from TD Securities.Normal curve: eg, December 1984
When bond traders expect the economy to have normal rates of growth,
without significant changes in inflation rates, the yield curve slopes gently
upward.In the absence of economic disruptions, traders who risk their money for
longer periods expect to get a bigger reward (in the form of higher interest)
than those who risk their capital for shorter time periods. So, as maturities
lengthen, interest rates typically get progressively higher and the curve
goes up.December 1984, marked the middle of the longest period of post-war
expansion. Global economic growth rates were in a steady quarterly range
of 2% to 5%. The major equity market indexes were posting strong gains.
The yield curve during this period was normal and this is the kind of curve
most closely associated with the usual comfort zone of an economic and
stock market expansion.Steep curve: eg, April 1992
Typically, the yield on 30-year Treasury bonds is two to three percentage
points above the yield on three-month Treasury bills, ie, 200 to 300 basis
points higher. When the gap gets wider than that — and the slope of the
yield curve increases sharply — long-term bond holders are sending a
message that they believe the economy will grow very quickly in the future.This shape is typical at the beginning of an economic expansion, just after
the end of a period of recession. Economic stagnation will have depressed
short-term interest rates at that point, but once the demand for capital
(and fear of inflation) is re-established by rising economic activity, rates
begin to lift.Long-term traders fear being locked into low rates, so they demand greater
compensation much more quickly than short-term lenders who face less
risk. Short-term traders can trade out of T-bills in a matter of months,
giving them the flexibility to buy higher-yielding securities should the
opportunity arise.In April 1992, the spread between short- and long-term rates was five
percentage points, indicating that bond traders were anticipating an
extremely strong economy in the future and had bid up long-term rates to
create a steep yield curve. They were right. The GDP, which is a measure
of a country’s economy, was expanding in the US at 3% a year by 1993.Short-term interest rates (which slumped to 20-year lows right after the
1991 recession) had, by October 1994, jumped two full percentage points
(ie, 200 basis points), flattening the curve into a more normal shape.Equity traders who had seen the steep yield curve in April 1992 and had
bet on economic expansion and growing corporate profits were rewarded;
the broad equity market gained 20% over the next two years.Inverted curve, eg, August 1981
At first glance, an inverted yield curve seems a contradiction. Why would
long-term traders settle for lower yields when short-term traders take so
much less risk? The answer is that long-term traders will settle for lower
yields now if they think rates — and the economy — are going even lower
in the future. They’re betting that this is their last chance to lock-in rates
before the bottom falls out.Look at the situation in August 1981. Earlier that year, the US Federal
Reserve had begun to lower the Federal Funds Rate in an attempt to
forestall a slowing economy. Recession fears had convinced bond traders
that this was their last chance to lock in 10% yields for the next few years.
The collective market instinct was right.A GDP chart demonstrates just how bad things got in 1981. Interest rates
fell dramatically for the next five years as the economy tanked. Thirty-
year bond yields went from 14% to 7% while short-term rates, which started
much higher at 15%, fell to below 6%. For equity traders, the 1981-82 bear
phase was brutal. However, traders who bought a long-maturity bond
definitely had success. I recall participating in an investment roundtable at
the Toronto Press Club for a major publisher, calling those 15% government
bonds held in a tax-deferred plan to be the “Buy of the Generation”.Inverted yield curves are uncommon and it pays to never ignore them.
They are almost always followed by economic slowdown or recession, as
well as lower interest rates across the board.Flat curve, eg, April 1989
To become inverted, the yield curve must pass through a period where
long-term yields are the same as short-term rates. When that happens the
shape will appear to be flat or, more commonly, a little raised in the
middle.Not all flat or humped curves turn into fully inverted curves, mind you.
Otherwise all traders would get rich simply plunking their savings into 30year
bonds the day they saw long bond yields start falling toward short-
term levels.On the other hand, don’t discount a flat or humped curve just because it
doesn’t guarantee a coming recession. The odds are still pretty good that
economic slowdown and lower interest rates will follow a period of
flattening yields. That’s what happened in 1989 when 30-year bond yields
were less than three-year yields for about five months. The curve then
straightened out and began to look more normal at the beginning of 1990.Was this a false alarm? No, because GDP charts show that the economy
sagged in June and fell into recession in 1991. Equity market charts show
that the stock market also took a dive in mid-1989 and plummeted in
early 1991. Short- and medium-term rates were four percentage points
lower by the end of 1992.As I write this book (August 2007), the 30-year Treasury bonds are yielding
4.82% and the 30-day Treasury bills are yielding 4.89%, so there is an
inverted yield curve. The yield curve went inverted early in 4Q06. Many
economists have forecasted economic slowdown and/or recession in 2008.
Applying your knowledge of the yield curveSay you inherited $10,000 and want to have it available in 10 years. You
have several choices:
(1) A 10-year Treasury bond to be held to maturity. This would be fine
if you expected interest rates to stay high.
(2) A six-month Treasury bill to be rolled over at maturity repeatedly
over the 10 years. This would be wise if you might need the money
and if interest rates are high and expected to rise.
(3) A two-year Treasury note that, at maturity, would be turned into an
eight-year bond. This would be fine if short-term rates are high and
expected to drop and long-term rates are low and expected to rise.
(4) A 15-year bond to be sold after 10 years. This would be worth
considering if you expect interest rates to fall, but it has the most
risk.As with all technical indicators, the yield curve is not always correctly
interpreted, but it’s a useful tool in trying to predict future interest rates.
It can aid traders in visualizing the profit potential of various holdings
with different maturities.But with a thorough understanding, it can do so much more. It can serve
as the foundation of your entire trading approach.Similarly, an understanding of the bond market, interest rates and cash
management will clearly be a help to traders who are mostly interested in
stocks.