By Deepta Bolaky The intermarket relationships between commodities, currency, equity and bond markets are key in understanding the way the markets interact and move. Some markets will move with each other while others will move against each other. There are different types of bonds but for the purpose of this article, we will use the U.S Treasuries, which are considered one of the safest bonds.
The importance of the bond market The bond market is very powerful and helps traders gauge the performance of an economy. Given that bonds provide a fixed interest payment, investors tend to buy them when the economy or stock market is declining. Alternatively, during times where the economy is strong or when the stock market is doing well, investors are less likely to purchase bonds as they know they can find alternative investment options for higher returns.
Before we discuss how bonds can help investors in predicting the economy, it is important to understand the relationship between bond prices and yields together with its relationship with interest rates. This part can be confusing for new investors. Put simply, when the economy is expanding, investors move away from safe havens and take more risks.
In that case, demand for bonds decreases which cause a drop in bond prices. Given that the interest payments remain fixed, when the bond value decreases, bond yields will inevitably increase. This is so because yields are the interest payments divided by the par value.
Therefore, bond prices and yields are inversely correlated. Yields vs short and long-term interest rates Yields and interest rates are quite similar with the main difference being that each term are used to refer to different financial instruments. The yield curve is used to depict the relationship between the short-term and long-term interest rates.
Normally, investors demand more compensation to lock their money for longer periods. Therefore, we expect the yield curve to be an upward slopping curve. A steep curve indicates that investors are expecting future inflation and strong economic growth in the future.
Now, why is the US yield spread between the 2yr and 10yr treasury alarming? Such thin yield spread is a matter of concern because the US short and long-term yields are currently at its narrowest level in more than a decade. This means that a hawkish Fed have managed to increase short-term yields but not the longer-term yields.
In other words, demand for short-term bonds have decreased but not for longer term ones. There is a risk of an inverted yield curve if this situation persists. The flattening yield curve might therefore indicate that investors are not convinced that the economic growth will be maintained in the long run despite that the fact that the Fed’s are confident about the strength of its economy.
When an economy gains momentum, the curve normally tends to steepen not flatten. Even the Fed policy markets remained perplexed on why the curve is shrinking. Will another rate hike in September put a pressure on the yields spread?
Are the Federal Reserve going to halt its increase in interest rate if the spread tightens further? Does an inverted curve mean the same thing as it once did? As the Fed increases interest rates, investors need to eye the yield curve as a sign and remain cautious about the outlook for economic growth.
However, it is worth mentioning that based on previous inversion of yield curves where a recession has followed, a stock market rout did not occur right away. It actually jumped amid the turbulence.
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