Yield Curve reads growth or inflation?
The yield curve plots the yield of government securities against their respective maturities. Studying the evolution and shape of a currencies yield curve not only details the price of credit available in that currency but also the aggregate interest rate expectations going forward. In the classical Austrian school of economics, one assumes that credit is only available from governments and banks. At present credit is available from just about everywhere, including foreign governments, hedge funds and multinationals. For example, General Motors over recent years has generated more revenue from selling loans to buy its cars than the cars themselves. Such secondary credit markets and their associated curves such as LIBOR/Swap rates are highly relevant to present credit conditions. However, the principle influence in all these markets will still be the underlying currency yield curve with the US Treasury market being by far the most influential and important such market.
Over the past two weeks global equity and bond markets have been over shadowed by a marked and abrupt shift in the level and shape of the US yield curve. The benchmark ten year US Treasury bond has moved from a yield of 4.6 percent, to over 5.25 per cent. With the yield curve evolving from being ‘flat’ and pricing in a cut in US interest rates in the next year, to being ‘normal’ where further interest rate increases are deemed possible than an imminent cut be been completely discounted. Quantitatively driven relative trading strategies ensured that this shift in the USD curve dragged the Uk Gilt and Euro curve higher resulting in immediate loses for global bond portfolios, with an associated sell-off in global equity markets where the DOW has fallen more than 3 per cent from its recent peak.
Higher interest rates will undoubtedly squeeze the real estate sector, reduce the prices offered in private equity buy-outs and ultimately act as a drag on corporate profitability. Pension fund so called liability matching could also see further selling of bonds, as higher yields equates to less bond holdings needed to ensure a given future cash flow. Market prices reflected these developments with obviously targets such as UK mortgage lenders Bradford and Bingley and HBOS in the UK; and house builders and REITs in the US being hardest hit. Regulated utilities where also marked lower as bonds became a more competitive source of stable cash flows.
However you slice it, higher interest rates are not good for equities. One would prefer such moves to result from stronger than expected growth as opposed to inflation expectations, but I for one are not sure that this in the case.
Web Resources:
GBP/USD Yield Curves: http://www.yieldcurve.com/marketyieldcurve.asp
Dow vs USD Yield Curve: http://stockcharts.com/charts/YieldCurve.html
LIBOR/Swap Rates: http://www.swaprates.co.uk
January 11th, 2009 at 3:49 pm
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