Some people (not our readers of course) naively think that the stock market somehow represents the health of the economy. Presidents on both sides of the aisle brag that a booming stock market is proof of how great their economic programs really are.
But the truth is the stock market’s connection to the actual economy is tenuous at best.
So what’s really at the heart and soul of the health of the economy?
Capital… a.k.a. Money.
And interest rates are key to understanding money.
You see, interest rates are the cost of capital… the “price” you pay for money. They indicate what the demand for money is now and even 10 years down the road.
And where interest rates are concerned, if you want a real glimpse into the future of the economy, you want to look at something called the “yield curve.”
It’s an obscure concept to most individuals — but in truth, the yield curve is like a crystal ball. Today, and in your coming letters, I want to introduce you to the yield curve as a predictive tool. And explain why you need to be paying attention to it.
But before we talk about the yield curve specifically, just so we’re all on the same page, we need to get clear on how the bond market works…
How Bonds (and their yields) Trade
Let’s keep this simple…
A bond is “born” at a bond auction. At that initial auction, it enters the world with a coupon yield (the interest rate the bond will pay — let’s say for example 5%) and a face value price (called “par” represented by 100). Don’t worry about anything beyond that for now.
So at auction, let’s say there’s a particular bond that matures in 10 years and is issued with a face value price of 100 (or “par”) pays a yield of 5%.
Now let’s say you buy one of those bonds. When the bond matures, you’ll get back the face value that you paid, plus all the annual interest payments.
But let’s say, a year later, you want to sell your bond for some reason. You’ll go to the secondary market to see what’s trading. If yields have risen, let’s say to 6%, your bond that’s paying 5% isn’t looking quite so attractive. No one is going to pay full face value (par) for a bond yielding less than what the market is.
To make up for this, the price of your bond falls or is “discounted” to attract buyers.
The exact opposite happens when rates fall, let’s say to 4%. Now your 5% bond yields more than the market and someone would be willing to pay you more than face value (above par) to buy it.
That’s how the bond market trades. Yields go up, bond prices go down. And vice versa.
But here’s the thing… yields (interest rates) don’t just move up and down on their own. They are the result of expectation. And this is why the yield curve becomes so important.
Yield Curve 101
So what is the yield curve anyway?
The yield curve is a line that connects the yields of different maturations on similar debt instruments.
Put a little more simply it’s the difference between longer and shorter term interest rates.
Put even more simply, here’s a picture of what the U.S.Treasury yield curve might look like:
This slope would be called a normal yield curve because investors typically ask for higher yields the longer they are asked to commit their money.
So at any given time, 10-year T-bond will pay a higher yield than a 3-year T-note which will pay more than a 6-month T-bill.
There’s another reason this kind of slope is called normal…
When the markets believe the economy is on a normal growth trajectory — you get a normal yield curve.
As yields at different maturities move up and down in the market, the shape of the curve will change too.
The yield curve can change from “normal” to “flat.”
It can also “invert”…
Now if a normal yield curve suggests normal, healthy economic growth, you can guess that an “inverted” yield curve is obviously signaling some sort of trouble.
This way of viewing the yield curve — across all maturities — is basically a snapshot in time. In your next issue I’m going to show you a different way of tracking yield curve movement and a little bit of its predictive power…
Make the trend your friend,
Editor, Streetlight Daily