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Breaking down the Yield Curve – September 2022

Breaking down the Yield Curve – September 2022

September 09, 2021
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Fixed income markets can be confusing to seasoned investment professionals at times, so it’s completely understandable for common, everyday investors to have little thought into this market.  Often, a retail investor’s fixed income inclusion comes from following a U.S. Aggregate Bond Index and calling it a day.  However, looking at the yield curve gives us some insight into what we think is happening in the overall economy (our yield curve is one of the most reliable predictors of recession) and having knowledge of what’s happening with it can allow us to position ourselves appropriately to gain from both the diversifying nature of bonds as well as being in the proper investments to benefit from our views on rates.  This week, I will look at the short end and long end of the curve as well as the overall levels of the curve and explain a bit about what these could mean, as well as how I try to position portfolios to benefit from what we see in the overall curve.  All of the rates I use come from the U.S. Department of the Treasury’s Resource Center Daily Yield Curve Rates.

Yield Curve – Short Rates

When I refer to short rates, I’m specifically referring to the yields on U.S. government bonds, recently issued with maturities less than 2 years.  I tend to focus in on the 2-year bond for two reasons.  First, it is commonly used in calculating changes in the slope and curvature of the overall curve.  Second, it responds to changes in Federal Reserve policy and rate decisions and gives us an understanding of how the Fed is adjusting their rates to reach their inflation target.  On 9/1 of this year, the 2-year rate was holding at 0.20%.  This rate has been in place since the Fed responded to the pandemic in March of 2020 by lowering the target interest rate to a range of 0% to 0.25%.  At the short end of the curve, we will not see changes in this rate until the Fed starts to raise rates to combat inflation.  This means two things for common investors.  One, there is no yield on short term investments deemed “risk-free” by the government.  Safe investments commonly available to investors such as CD’s, interest on money market savings, and the short-term bonds we are talking about will have very little interest earned for quite some time yet, as the Fed continues to express that they will not raise these rates until late 2022.

Yield Curve – Long Rates

On the other end of the curve, the long-term bonds consider extra risk in the yield.  The difference between the 30-year rate and the 2-year rate can have several small components, but it mostly boils down to uncertainty.  A lot more can happen in a 30-year period than a 2-year period, and we require extra compensation to take on the risk.  The 30-year yield reflects the sentiment on long-term investment risk.  When long rates go up, it reflects investors needing more compensation to invest in a long-term bond, and price falls to make it more attractive for an investor to do so.  What I watch in long-term bonds are price levels.  When long-term rates are very low and are likely to go up, long-term bonds are not attractive investments, due to a measure of bond risk called duration.  Long term bonds have longer durations and are affected by rate movements far more than short term bonds.  On 9/1, the 30-year treasury rate was at 1.92%, which is considered a very low rate historically.  Now that we have a basic idea of short rates and long rates, let’s look at how I use them to interpret the overall curve and make investment choices in fixed-income securities.

Yield Curve Measurement

I focus on reading changes in the yield curve in three specific measures that give me insight into the direction rates are trending.  The “level” of the yield curve is the general movement of the overall curve up or down.  A rising curve means bond prices are falling, and a falling curve means bond prices are rising.  The “slope” of the curve is measured by taking the 30-year rate and subtracting the 2-year rate, giving us a “spread.”  This gives me a measure of the curve “flattening” or “steepening.”  A flattening curve usually means that rates at the short end of the curve are rising faster than rates at the long end of the curve.  Our current reading shows the 30yr-2yr spread at 1.72%, which steepened a little from a measurement of 1.69% a month prior in August.  Lastly, I measure curvature by using the 10-year rate in addition to the 2-year and 30-year to measure the amount of curve.  Looking at our current yield curve graphic, you can see that the curve starts with low rates and then accelerates quickly before flattening out somewhat from the 5-year rates to the 30-year.  The curvature reading on 9/1 was 0.48%, which is higher than August’s reading of 0.37%.

September Assessment

So, what do all those numbers mean, and how do I read them?  First, bond prices have risen in the past 3 months, but have fallen slightly in the past month.  The overall level is the most significant measure of return in bonds, so I watch that measure the closest.  When the level is falling, this means yields are falling, and bond prices are on the rise.  This has been good for clients with significant bond exposure, but with rates at historic lows, it’s very difficult to say that rates will continue to fall.  Over the past 3 months, the slope of the yield curve has flattened, with short end rates rising slightly and long-term rates falling.  This has provided investors in long-term bonds with return through long-term bonds increasing in price.  A flattening yield curve usually rewards investors positioned at the long and short end of the yield curve, which is referred to as a “barbell” strategy.  Lastly, there is less “curvature” in the yield curve over the past 3 months.  When there is less curvature, being positioned in the center of the curve is better.   Looking at the big picture, I’m observing the slope and curvature measures telling me different stories about return, but the overall level of rates has fallen.  With the past month signaling rates have started to rise, I am positioning most of my fixed income investments in shorter-term maturities that will have less sensitivity to the rising interest rates in the event they should they continue to rise.

Thanks for taking the time to read the blog this week!  I would love the opportunity to sit down and discuss how I can help you improve your financial picture.  I specialize in creating focused plans for clients planning for retirement as well as managing those retirement plans to make sure my clients enjoy the retirement years to the fullest.  I also work with a variety of other financial issues.  If you would like to schedule a free consultation, please call the office at the number below, or click the link to schedule a virtual or in-person meeting (or phone call) by setting a time that works for you!  I would love to hear from you!  Enjoy the rest of your week!

Best wishes,

Mitch Bodenmiller

(937) 424-3269

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