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Friday, October 22, 2010

Yield Curve - Part 2

In "Yield Curve - Part 1," we looked at the Treasury yield curve - which shows the yields of "on-the-run" Treasuries. On the run Treasuries are the most recently issued Treasuries. Bond investors study the curve to determine if the pick-up in yield for extending maturity (i.e. buying bonds with a longer maturity) is worth the incremental risk. For example, the yield on the 10-year today is 2.55% and the yield on the 2-year is a pathetic 0.35%. Is it worth taking on the additional risk of the 10-year bond (its price will drop sharply if interest rates rise) to pick up an additional 2.10% (i.e. 210 basis points) in yield? There is no way to get around this fundamental trade-off between risk and return.

Analysts study the curve to assess the likely course of the economy. A steep curve (i.e. the yield on longer-term bonds is considerably above shorter-term bonds) typically indicates a pick-up in economic activity. A steep curve is generally the result of an aggressive Fed pushing short-term rates lower. Today's curve is steep.

A flat or inverted curve typically presages a slowing economy. It generally follows an aggressive Fed-tightening move whereby short-term rates are driven higher. If we experience an inflationary episode in the coming years, this is probably what we'll see.

As a point of useful information, it is generally agreed that the Fed controls short-term rates by targeting the federal funds rate at its FOMC meeting; and longer-term rates reflect inflationary expectations.

In today's environment, the Fed seems to be trying (and succeeding somewhat) to influence longer-term rates by its so-called policy of "quantitative easing." This policy involves buying longer-term securities which pushes their prices higher and yields lower.

Although the Treasury yield curve is the most closely followed, there are others worth knowing about. One such is the TIPS curve which shows the yield on various maturity Treasury Inflation Protected bonds. This curve can be found at the Bloomberg site :

CLICK TO ENLARGE Analysts like to take the difference between the 10-year Treasury and the 10-year TIPS as a measure of inflationary expectations. Today that difference is 2.12% (2.54 - .42). If you buy the 10-year TIPS and inflation averages greater than 2.12%, you are better off versus the non-inflation adjusted Treasury because the principal amount on the TIPS is adjusted upwards by the rate of inflation. The 2.12% is viewed as the break-even rate.

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