Operation with bonds and other debt instruments is a big par of investment and short-term speculation operations in the financial markets.

Talks about FOREX liquidity are quite simplified. It is difficult to calculate the volume in the World cause it is a spot market and there are question how it is calculated and what is included in it? At the same time it is a fact (cause you can check it) that the 10 year T-note futures contract volume which is traded at eCBOT is $100 billion a day and even more. And this is only one contract!

Now lets move to the topic of the article – yield curve and bond yield curve.

Bond yield curve in the market. Its types and changes.

I am not going to show you graphs from books. I assume you have seen them, that’s so boring don’t you think so? Why not to look in the market and we will! The question is why (and it have to be so!)  yield is higher for bonds with a later maturity date?

Yield curve T-bonds, 2005

As you can see the longer is period the higher is yield. Why? Because if you freeze your money buying a bond or depositing them into a bank you want to get something for it. First of all, you want to get a premium for risks and the longer period is the more unpredictable futures is and more risks may appear. Secondly, the longer you freeze money the less convenient you feel: you can’t do anything with your money but you can buy a car for example or invest into a business therefore you want payment for time too.

Here I showed you a normal yield curve with a positive slope but it is not always normal.

Negative yield curve slope

There are several theories which try to explain why happen market conditions in which yield curve slope is negative:

Expectations theory – people expect price (rate) changes in future and today value instruments basing on their expectation. I like it the most, easy to understand and work in practice: There are market conditions (for example last crisis in year 2007-2008) when people expect that interest rates will fall in future, therefore you are offered to invest your money into debt instruments for longer time for lower rate. 

Liquidity premium theory - long-term instrument is more influenced by price (rate) changes, therefore if interest rate change long-term instruments’ price will change more than shot term ones. Can’t say I really like it. Sound more like a fact than an explanation but maybe it is my fault.

Segmentation theory - demand and supply factors work in different way for different term instruments.

It is considered that all three theories work but depending on market conditions one or another prevail. However for me it is enough to have the first one.

The yield curve slope change in time depending on market conditions. Short term rates can grow faster than long term and vise versa. For example, when Fed or any other Central Bank influence short term interest rates in the way of increasing them, short term rates may be on the same level as long term (flat yield curve) or even higher. This is called a yield curve shrinkage (compression).

Let’s look at this shrinkage on the US interest rate example. Basically, compression happens when Fed decrease excess bank reserves selling bonds which are held at SOMA. Free money supply decrease in US markets affect effective fed fund rates. As a result all spot interest rates increase and short term rates are affected first. At the same time market participants are not idiots and see that Fed has taken into hands his “war axe” in order to fight inflation and it means that inflation in future may decrease what will influence later the interest rates and they will decrease. Such situations are seen just before a crisis (actually before economy stagnation but we don’t have stagnation we have crises, that’s funnier: if fall than fall like a rock!) when Fed or European Central Bank tries to stop the economy overheating.

As you can see on the graph before the first circle in year 2000, the short-term bond yield was lower than longer term bonds but in year 2000 everything changes it became the highest. Once more it happened in year 2006-2007 just before the downturn in stock markets. (That’s nice that each 6-8 year during several last decades we get a crisis, I’ll wait for it in year 2015).

We can use this knowledge to predict large trend changes and/or continuations: if you see an interest rate shrinkage stock market is going to show his last power to grow.

Article written by Glebs Kabanovs was used.