Good Time To Go Fish(er)ing Around The Yield Curve

There are, in actuality, three variables to always keep in mind whenever interpreting.

The first, which we won’t delve much into today, is the relative nominal level. Even if everything is going right and the other two factors moving favorably, should the entire curve stay historically low that’s already a red flag.

What follows is the second element, that which was proposed at the outset: the relative direction of any changes in yields.

Third, to me the more if not most important is the curve’s shape. Steep or flat, how LT rates are behaving in the context of ST yields and rates.

So, it’s not as simple as: down = bad, good = up; though you can easily understand why that impression lingers in the public consciousness. If, on the contrary: 1. Rates overall stay low; 2. Even as LT yields may rise; 3. Should those LT rates be rising because of those in the ST; then that’s not the same at all.

Breaking down yields is a pretty simple process, too. We start with easy Fisherian decomposition which you can put in some kind of fancy econometric format if you desire. For our purposes here, there’s no need since we can effortlessly just eyeball the thing.

Term premiums are not science nor really math. They are made up and more than that they are rationalizations, truly Orwellian, intended to deny the obvious and straightforward signals coming from the very fundamental building blocks of all finance and economy. The entire notion is purposefully shrouded in unnecessarily complex concepts whose only true use is to attempt to answer for the otherwise inexcusable.

As I often write, Economists don’t understand bonds. But they know just enough of them to understand that they had better change the subject.

You can read the explanation why at the link above.

This leaves us with just two basic pieces: the expected path of ST rates and then what Irving Fisher realized more than a century ago, forward longer run expectations about growth/inflation. The LT yield is some mixed up combination of those two.

From ultra-low LT yields post-2008, these were supposed to move closer to what they used to be. They never once did for equally obvious reasons; the economic prospects for growth and inflation never materially improved despite anything the Fed did to the contrary (especially 2017-18).

But what about 2020 and now after?

What you easily find is how the initial reflationary period (defined loosely here as dating from the August 2020 lows through the first BOND ROUT!!!! topped out in mid-March 2021) was absolutely consistent with the good pattern – if only in two out of the three dimensions.

The expected path of ST rates was up if ever so slightly (represented by the 2-year UST yield which only ticked higher while the 5-year moved much farther) while growth and inflation expectations obviously then improved.

The curve steepened and nominal rates across it were going higher.

But the curve never traveled that far upward, meaning it didn’t actually break out in terms of our first criteria. Red flag. Topping out with the 10s at jut 1.74% wasn’t as much of a shift as it had been made out to be.

The argument, such that there may be any, is how the market has performed since that point. I think you can literally see why it isn’t or shouldn’t be much of one:

At each respective top along the way, expectations for ST rates (confirmed by eurodollar futures) have moved up, though especially so going back to October.

Because of this, it leaves expected growth and inflation to have shrunken materially since that mid-March inflection entirely consistent with the third criteria. Flat curves mean flat curves and unless they are flattening in accordance with at least Criteria #1 (because curves aren’t supposed to be steep, but they are supposed to go flat at a normal, healthy interest rate level far, far above what you see here) then essentially that’s the ballgame.

The market is both rejecting taper and rate hikes and simultaneously, because of it, forming what’s very clearly shaping up as Conundrum No5.

So, 2022 begins with modestly rising, suspiciously modest rising yields but flattening curve (not good) at still obscenely low nominal levels (more not good).

The meaningful difference between rising yields late 2021/early 2022 is night and day from rising yields late 2020/early 2021: