The Yield Curve and Investor Sentiment - Part One | Options Trading Strategies

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The Yield Curve and Investor Sentiment - Part One

Monday, 25 August 2008 11:22

The yield curve is something that analysts and professionals will track but is rarely talked about by smaller individual traders. This is a very important topic right now as the market is hearing echoes of the credit crisis of July 2007. There are some important differences between now and then and some of these differences are related to the yield curve and what it is telling us about investor sentiment. curve

The yield curve is a simple comparison of short term, mid term and long term bond yields. A bond's yield is how much it will return to you on an annualized basis from the time you purchase it until it matures. Typically the "curve" of yields means that you will be paid more for a long term bond and less for a short term one. This is because it is riskier to tie up your money for a long time than a shorter time frame. We can make pretty good estimates about what should happen in the next three months but no one knows what will happen over the next 30 years. That means that buyers will be paid a higher yield for the 30 year note than they will for the 13 week note. Long term buyers are being paid more to compensate for that uncertainty. For example, right now the yields on treasury notes looks like this.

13 Week - 1.645%
5 Year - 3.031%
10 Year - 3.782%
30 Year - 4.369%

The fact that the current yield curve looks "normal" is important and gives us some good information about investor expectations about the future. If short term bonds were paying a higher yield (which sometimes happens) we would draw very different conclusions about what traders think about the future. In the next section of this series we will talk about how the yield curve can give us guidance for the future and why it is telling us very different things today than it did in July 2007.

Are you an investor in fixed income? What do you think about the future of bonds?