Due to credit’s fundamental role in the current monetary system, one can reasonably infer that its cost structure on a risk-free basis may provide the investor with valuable information in the context of financial markets. In simplified terms, each point on a yield curve reflects the market’s consensus on an average risk-free rate achievable over a given period. This illustrates the first, purely informative function of the curve – it provides the observer with a starting point, from which one can further try to figure out what factors shape the yield of a given maturity.
Simultaneously, the interest rates term structure affects the marketplace in a reflexive manner. In the stable and prosperous economic climate, the yield curve is modestly upward sloping. Such conditions allow the investors to allocate their capital into long-term investments, with relatively low economic uncertainty. At the same time, the upward sloping yield curve incentivises such investments, allowing the economy for more growth over time.
Reflexivity - concept introduced by G. Soros, stating that prices in the financial markets influence human expectations, which in turn influence the behaviour and thus economic fundamentals. When introduced in 1987, the theory was in opposition to the consensus view that prices are derived purely from the equilibrium between supply and demand.
The shape of the yield curve is influenced by several factors, which vary for different segments of the curve. Whereas the short end is influenced by policymakers’ decisions about the level of the reference rate, longer maturities tend to manifest smaller interest rate sensitivity. The yield of the longest durations is composed mostly out of long-term growth and inflation expectations, and here the neutral rate of interest plays a much bigger role. Being aware that the interest rate policy has little influence on the interest rates over the long-term, market participants may perceive long end bonds as attractive even if their yield is lower than the current short-term rates – in such cases, the yield curve inverts.
An inverted yield curve may be interpreted in the same, dual sense. Informatively, it depicts the market’s consensus that the current level of short-term rates is unsustainable, and the long-term average will end up being lower, which broadly speaking is tied to lower growth, but also to the downward shift in the short end sometime in the future. At the same time, inversion influences the allocation of capital – if the short-term rates are higher than the long-term ones, investors have a clear incentive to invest in the money market rather than allocate their capital to real-economy investments with a longer duration. This, in turn, hinders economic growth, depriving the economy from the capital flows to the long-term investments.
Decomposing nominal bond yield
During his 2005 report before the Committee of Banking, Housing, and Urban Affairs, then-Fed Chair Alan Greenspan has (in)famously stated:
“Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. […] For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.”
Unfortunately, this statement is really far from reality, and its falsification requires only the basic perceptual and reasoning skills. The aim of this part of the article is to equip you with a toolkit that will allow you to analyse the bond market better than any Fed Chair, and what’s more important: with no conundrums.
In order to better understand the nominal bond yield, it is helpful to break it down into two basic components: real yield + breakeven inflation
The breakeven inflation rate is, in the simplest terms, the average inflation priced in by the market over a given maturity. It may be derived by rearranging the equation, i.e. taking the nominal bond yield and subtracting the yield of the inflation protected bond with the same maturity. For example, to extract 5-year breakeven inflation from the nominal U.S. Treasury curve, one should subtract the yield of the 5-year TIPS from the 5-year nominal bond.
TIPS (Treasury Inflation Protected Securities) - U.S. Inflation protected bonds, sold in maturities for 5, 10 and 30 years. While in TIPS the coupon rate is fixed, the principal is adjusted monthly by the monthly CPI increase. When coupon is calculated at a constant rate from the adjusted principal, the amount which is paid out differs.
When we take out the inflation component from the equation, we are left with the real yield – one that can also be derived from inflation-linked bonds. This yield represents inflation-adjusted costs of borrowing. Such an adjustment is necessary to assess whether the rate is high or low - for example, buying a two-year U.S. Treasury yielding 4% nominally may be a good investment when the CPI grows 2% per annum, but not so much when the CPI prints are in 7-8%.
The real yield may further serve as a useful tool for analysing potential investment decisions or the macroeconomic environment in general. In a positive real yield environment, the investors have a choice to make a bond investment or, in case they want to seek higher return, make a risk-bearing investment – for example invest in a stock. However, if the real yields are negative, investors seeking a positive real return have to assume some risk. In fact, one of the possible explanations for the impressive 2020/21 returns of a stock market is that in the zero interest rate environment combined with inflation, investors had to turn to stocks for chasing the positive real returns.
When evaluating the rates’ net influence on the economy, it is useful to analyse it from the relative point of view. Whether given (positive or negative) real yields serve as a boost to the economy, they have to be compared to the r*. As such, positive spread between real yields and r* serves as a brake for economic growth, making borrowing relatively costly.
r* (equilibrium real rate) – The rate which is neither expansionary nor contractionary for the economy in the long-run. The r* is influenced by multiple real-economy factors such as demographics, labour participation, and labour efficiency.
Due to its complex nature, incorporating the rate analysis to one’s investment framework may be a challenging task – especially that there also exist more complicated ways to decompose the bond yield. Nevertheless, in many cases it is the hassle worth taking, as it may give one a profound insight in what the markets are pricing in across various groups of assets.