The Yield Curve and Investor Sentiment

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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.

[VIDEO] The Yield Curve and Investor Sentiment: Part 1

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, as we write this 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.

Now that we understand the yield curve, it’s time to talk about how the yield curve can give us guidance for the future and why it is telling us very different things today (as we write this) than it did in July 2007.

The yield curve will change over time and these changes can be very important indications for what investors think about the market today and what they expect in the future. There are four main types of yield curves and these types can tell us a lot about how today’s curve differs from the credit crisis of July, 2007.

[Video] The Yield Curve and Investor Sentiment: Part 2

A yield curve can be inverted, flat, normal or steep. Inverted or flat yield curves are bearish while normal and steep curves are considered bullish.

Inverted Yield Curve

An inverted yield curve means that investors are being paid more for short term debt than long term debt. That is extremely bearish because it means that investors are expecting yields to drop significantly in the long term and that short term risk is high as well. An inverted yield curve has a striking correlation to bear equity markets. In the video I will show a couple recent examples of this kind of correlation.

Flat Yield Curve

A flat yield curve is also bearish for the same reasons an inverted curve is negative. A flat curve indicates a lack of investor confidence in the future. The last credit crisis in July of 2007 was correlated with a flat yield curve and followed an inverted curve earlier that year. This is one of the reasons why the correction in the stock market was so severe since last year.

Normal Yield Curve

A normal yield curve indicates lower short term yields and a mild increase between mid-term and long-term debt. This is a very common scenario and indicates a normal level of confidence about the future.

Steep Yield Curve

A steep yield curve is very bullish as traders expect better yields in the future. A steep yield curve means that longer term yields are much higher than short and mid-term yields. This type of curve is correlated with rallies in the stock market.

As we write this article there is a steep yield curve in the market and this is one of the most significant differences between this current market and conditions in July of 2007. While there is definitely still risk in the market, it is not the same kind of risk as it was in 2007.

Now that we’ve looked at the yield curve from a fundamental perspective — which is very useful and provides context for what drives short term and long term yields over time — it’s now time to look for changes in the yield curve on a shorter term basis using technical analysis. In this case, what we are looking for are changes in the yield curve that would indicate a shift in investor sentiment. A shift in investor sentiment will impact the stock market and can be used to adjust portfolio risk control measures.

One of the simplest types of analysis we can apply is to measure the relative change between long term and short term yields. For example, if rising long term yields relative to short term yields is bullish, then the stock market should improve in value. The more dramatic that change in relative values is the more important the subsequent affect it should have in the stock market.

[VIDEO] The Yield Curve and Investor Sentiment: Part 3

In the above video I will walk through applying a comparative relative strength analysis on short term yields represented by the 13-week yield index (IRX) and the 10 year yield index (TNX.) I will show how a sharp positive change in the relative performance of long term yields is correlated with a bullish change in the stock market. This is helpful because the accompanying change in investor sentiment should indicate increased risk for short traders or bears and potential entry opportunities for long investors and bulls.


Image courtesy Dominic’s Pics.