Yield Curve Dynamics

Yield Curve 101. When the yield curve flattens and eventually inverts, you worry. But it’s when the curve steepens late in the cycle as the Fed must react to a weaker labor market that you become really scared. Yield curve dynamics represent a crucial macro variable, as they inform us on today’s borrowing conditions and on the market future expectations for growth and inflation. An inverted yield curve often leads towards a recession because it chokes real-economy agents off with tight credit conditions (high front-end yields) which are reflected in weak future growth and inflation expectations (lower long-dated yields). A steep yield curve instead signals accessible borrowing costs (low front-end yields) feeding into expectations for solid growth and inflation down the road (high long-dated yields). Rapid changes in the shape of the yield curve at different stages of the cycle are a key macro variable to understand and incorporate in your portfolio allocation process. There are 4 main yield curve regimes to consider: 1) Bull Flattening = lower front-end yields, flatter curves. Think of 2016: Fed Funds already basically at 0% and weak global growth. Yields stay put at the front-end and could meaningfully move lower only at the long-end, hence bull-flattening the curve. 2) Bear Flattening = higher front-end yields, flatter curves. 2022 was the bear flattening year: Powell raised rates aggressively to fight inflation, but he ended up choking the economy off. This was reflected in lower future growth and inflation expectations at the long-end of the curve. Front-end rates went higher, but the curve bear-flattened. 3) Bear Steepening = higher front-end yields, steeper curves. October 2023: yields are rising but it’s the long end which dominates the move because investors think the economy can handle higher rates for longer and they start pushing up the term premium. Rare and potentially dangerous if growth isn’t strong. 4) Bull Steepening = lower front-end yields, steeper curves This move tends to happen ahead of recessions as the Fed must intervene and cut rapidly as the recession approaches. Front end yields tumble and long end yields drop too but more slowly. The yield curve is a key indicator every macro investor should watch. Did you enjoy this post? Let me know your thoughts in the comments!

Advanced Yield Curve Fitting in Fixed Income Analysis This post explores key yield curve fitting models, their practical applications, and how they support strategic decision-making in fixed income portfolios. 1. Why Yield Curve Fitting Matters in Fixed Income Yield curves reflect the market’s view on interest rates and are used extensively in fixed income analysis. Properly fitting a yield curve is essential for: -> Pricing Bonds Accurately – Provides fair valuation for bonds across different maturities, even when direct market quotes are unavailable. -> Managing Interest Rate Risk – Enables precise calculations of duration, convexity, and risk exposure, critical for hedging strategies. -> Market Forecasting & Rate Expectations – Helps in estimating forward rates, which guide investment and monetary policy decisions. -> Portfolio Optimization – Aligns asset allocation and risk strategies with yield curve movements, improving overall performance. 2. Key Models for Yield Curve Fitting Different models are used to estimate the yield curve, each with its own strengths and trade-offs. The choice of model depends on data availability, market conditions, and the intended application. -> Bootstrapping – A step-by-step method used to extract zero-coupon yields from observed bond prices. This approach is widely used in market environments where accuracy in short-term maturities is crucial. -> Cubic Spline Interpolation – A flexible, non-parametric technique that ensures a smooth yield curve by fitting piecewise polynomials between different maturities. It is useful when a precise, smooth curve is required, but it lacks economic interpretability. -> Nelson-Siegel-Svensson (NSS) Model – One of the most widely used parametric models in fixed income markets, capturing the yield curve’s level, slope, and curvature. This model is particularly effective for forecasting and portfolio risk management. -> Hermite Interpolation – A refinement over cubic splines that provides a smoother transition between maturities, making it useful for yield curve modeling in derivatives pricing. 3. Handling Maturities in Different Models Yield curve models vary in how they treat different maturities: -> Bootstrapping builds the curve sequentially, ensuring accurate short-term estimates but lacking a smooth fit for longer maturities. -> Spline-based models (cubic or Hermite) use observed maturities as key points and apply smooth transitions, making them ideal for market surveillance. -> Parametric models like NSS fit the entire yield curve simultaneously, balancing flexibility with economic interpretability, making them useful for central banks and fixed income investors. As fixed income markets evolve, the ability to apply advanced yield curve models effectively will remain a key differentiator for traders, analysts, and institutional investors. #FixedIncome #YieldCurve #QuantFinance #RiskManagement #PortfolioOptimization #InterestRates #FinancialModeling

The Yield Curve: A Window to the Bond Market's Future The yield curve is more than a simple graph depicting the relationship between interest rates and the maturity of securities; it is a nuanced indicator of the bond market's current and future state. Moorad Choudhry, in his insightful work "An Introduction to Banking," elucidates this concept with clarity, stating, "The yield curve tells us where the bond market is trading now. It also implies the level of trading for the future, or at least what the market thinks will happen in the future. In other words, it is a good indicator of the future level of the market." This observation is essential for both industry professionals and investors. The yield curve provides a snapshot of the market's expectations for interest rates, inflation, and economic growth. By analysing its shape – whether upward sloping, flat, or inverted – one can gauge the market sentiment towards future economic conditions. An upward sloping curve, for example, suggests that investors expect higher interest rates in the future, often associated with economic expansion. Conversely, an inverted yield curve may indicate anticipation of a downturn. However, it is crucial to approach this tool with a prudent mindset. While the yield curve is a beneficial indicator, its interpretation requires a conservative approach. Economic conditions are subject to change, influenced by numerous factors beyond the bond market's expectations. Therefore, while the yield curve offers valuable insights, it is equally important to consider other economic indicators and analyses to form a realistic outlook on future market conditions. The ability to interpret the yield curve is a valuable skill in the treasury and investment sectors, enabling professionals to make informed decisions. Understanding this concept enhances our ability to predict market trends, assess risks, and strategise investments more effectively. As we navigate the complexities of the financial markets, the insights offered by experts such as Moorad Choudhry are indispensable. They provide a foundation for understanding essential concepts like the yield curve, which, in turn, allows for more accurate and strategic financial planning. Reference: Choudhry, M. (2018). An Introduction to Banking. 2nd ed. Chichester, West Sussex: Wiley, p.133.

Upside-Down……..625 Days & Counting It’s official, 2’s--10’s UST are upside-down for 625 days and counting, the longest ever recorded (see bar chart below). We have not had a recession, which is typical of this yield curve configuration, but we have seen ‘things starting to break’, including: Companies too levered with floating rated debt (Broadly Syndicated Loans and Direct Lending) as liquid and private loan default rates have increased from sub-1% to 4%+, the highest level post-GFC (2009). Commercial Real Estate DQ rates now their highest level since the GFC, rising from sub-1% to ~6% (led by the office sector) as CRE has had its sharpest decline in valuations since 1990-91. Regional & small banking problems abound as insolvency is in full view, but not often discussed; Large Banks are well-capitalized with fortress balance sheets, however, it’s a tale of two cities as select regionals and many small banks remain under pressure from deposit outflows, high funding costs & greater loan-loss provisions, witnessed during SVB’s failure; Basel III Endgame is coming, providing regulatory constraints for banks, and significant investment opportunities for credit managers. Consumers overall are strong as bull, however, those with lower credit scores are paying the price as credit card balances have risen to record levels while the financing charge rose from ~16% in 2021 to ~23% today. Housing, energy, food, automobile costs have risen sharply during the past 3 years, exhausting savings accumulated during the pandemic for the bottom-40%-income households. The good news is that the Fed will likely begin to ease this summer, however, they will move too slowly for the vulnerable, and as rates stay higher for longer, it alleviates little pressure for the most leveraged/vulnerable sectors of the economy. When the Fed eases, the yield curve will begin to normalize, but it’s likely 6+ months before 2-10s become positive. DB & Bloomberg track data going back to 1950’s, showing the yield curve has never been this inverted for such a long period of time. The Fed has remained vigilant as inflation has remained above their goals, but the Fed will eventually win this battle, no doubt in my mind. It has been hard for the Fed to slow growth/inflation since fiscal stimulus has offset monetary tightening. Yes, you are correct; it is illogical (irresponsible too) that our government would inject such massive fiscal stimulation, while simultaneously tightening monetary policy. Neither John Maynard Keynes nor Milton Friedman would ever believe a government would do such a thing. We will get through this though, great countries always do. The economy is strong, Powell just revised GDP from 1.4% to 2.1% so that implies it’s still Higher for Longer. Sounds like Goldilocks to me so my advice is that investors take what the Fed gives you —> the highest SOFR rate in 20+ years.

What do rock legends AC/DC know about the US bond market? …they know the yield curve is “Back in Black” ⚡️🎸⚡️ As the chart shows, the US yield curve has been inverted since March 2022. Yesterday’s dis-inversion - and the yield curve moving back into the black - shouldn’t really surprise us. After all, short term bond yields have fallen quickly over the summer, as expectations for Fed cuts have grown. Traders now assume some 100bp of Fed cuts before the end of the year, and policy rates at 3.5% before the middle of 2025. What’s more, Powell’s recent speech - which shifted the Fed’s focus away from inflation and toward unemployment - has validated expectations for an imminent Fed and global rate cut cycle But the concerning thing here is that a dis-inverting yield curve, driven by bull steepening, is a robust leading indicator of recession. Even if the yield curve is just a “mirror”, reflecting the bond market’s best guess about future interest rates, it looks like an important cyclical change is underway as growth and labour market data cool quickly. That should put investors on alert, although a soft-ish landing remains our base case I still expect the yield curve to “structurally steepen”. But the most important thing to watch now is how far - and how fast- the curve steeepens. A gradual steepening toward a normal, say +50bp slope, would be fully consistent with a soft landing, and a broadening out pattern in stock markets. A more aggressive steepening would be a worrying reflection of a harder economic landing materialising … and that might leave investors “Thunderstruck” , or even on a “Highway to Hell” ⚡️🎸⚡️ #acdc #economy #investing

Yield Curve YTD Bonds are outperforming YTD based on the belly of the curve rallying 35-40bps. While the front end and back end are unchanged, the curve has taken on a pretty absurd shape, implying near term stagnation with long term inflation (stagflation). If inflation persists and the unemployment stays low, which the latest numbers imply, we could see a reversal of the first half of the year and much lower total returns for duration focused bond portfolios. This curve is a perfect setup for floating-rate bonds, which would benefit from potential Fed cuts and actually benefit from the belly of the curve selling off.

Here is a quick analysis of mine on both the equity & the fixed income market in March 2024. (Only for educational purposes) https://lnkd.in/dk4EzRaB The video encapsulates : ➡️Current state of equity markets ➡️Forward trailing P/E & P/B for Nifty 50, Nifty Bank & comparison against past averages. ➡️Fundamental analysis on sectors. ➡️View on multiple sector valuations & how to analyse on your own. ➡️View on European, USA, Japan, China, India & other emerging markets. ➡️Soft landing in USA. ➡️Rising, inverted & flattening yield curve. ➡️Discussion on yield curve for USA V/S India ➡️Current Bull steepening yield curve. ➡️Yield spread & corporate spread. ➡️Discussion on duration management strategies through long duration & short duration bonds. ➡️Further discussion on intermediate credit, MBS, Pass-through agency loans & crossover credit in Europe. ➡️Duration neutral strategy. ➡️Mid & small cap stress testing. ➡️Discussion on GDP V/S GVA #investmentbanking #indianeconomy #useconomy #chineseeconomy #japanesemarket #europeanmarkets #equitymarkets #fixedincome #gdpgrowth #valuation #yieldcurve Anil Ghelani, CFA Peeyush Chitlangia, CFA Kirtan A Shah Devan Bhalla Preeti Parashar Pawan Khatri, CFA Kartik Rajpara Mihir Dedhiya, CFA, CA

"But wait, the yield curve is finally disinverting! Isn't that a good sign? No. The inversion (when the 10-year yield goes below the 2-year or 3-month yield) tells you a recession is coming; the disinversion, when short ends yields start plunging, typically means the recession is actually upon us. The two-year yield was over 5% at the end of April; it has since plunged to 3.8% as the market prices in more Fed cuts and a slowing economy. This is similarly why analysts like Michael Hartnett at Bank of America warn you should typically 'sell the first cut.'"