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Yield to the Curve (Part 1)

By Jay Frank, eSignal Product Manager

One of the recent improvements in the eSignal software was the addition of the Forward / Yield Curve window. This multifaceted tool can be an amazing predictor of the overall health of world economies or simply finding liquidity in commodity markets. Let's take a closer look at this window, specifically for Yield Curves, and the theories surrounding this chart type.

Curves Are a Beauteous Thing

Beyond the not-so-obvious comparison of a yield curve chart to a shapely human figure, eSignal's Forward / Yield Curve window does have a lot going for it. Broadly speaking, an inverted yield curve has picked out market tops nearly every time in the last 30 years, and that can result in some pretty beautiful returns. Before we get to what the different shapes are, we'll first start with the basics of what a yield curve is.

Essentially, it is a plot of yield values across a given time horizon. Each treasury security has a specific yield value based on its maturity date, purchase price and face value.

Long-term investors typically expect a higher return on their loan to the government because they are incurring more risk due to the potential down turn over a longer period of time. Short-term investors often accept a lower return because their assets are locked up for less time and are less risky because of it.

Yield Curve Types

There are three common shapes of a yield curve:

1. Normal: The rate of return for long-term bonds is higher than short-term bills. Typically, this is a rounded parabolic shape showing that, the longer the time to maturity, the greater the yield. In fact, as of this writing, the current shape of the U.S. Treasury Bonds is just this.
   
   
   
   
2. Inverted: This shape occurs when long-term investors are fearing that the markets are primed for a significant down turn and need to capture these perceived high interest rates while the getting is good. Because of the laws of supply and demand, this rush in snatching up long-term securities causes the price to go up. The yield, by its nature, is indirectly proportional to the bond's price, and, as a result, the yield heads lower. If the long-term yields are less than the short-term yields, an inverted curve appears.
   
   The last time an inverted curve appeared in U.S. markets was November 2006 - March 2007, approximately six months before one of the largest down turns in the history of the U.S. markets.
   
   
3. Flat: The flat yield curve is pretty self-describing. This occurs when the short-term and long-term bond investors are approximately rewarded the same yield. This signals a period of uncertainty because the markets have not fully processed a potential change in trend.
   
   The last time a flat yield curve occurred was just after the inverted curve took place; specifically, this occurred between April and October of 2007. Certainly, this was a period of confusion because the bond market was saying one thing while the Dow and S&P500 continued their upward climb. As many technical chartists know, divergences such as these typically indicate a significant change in market direction.

Next Month

I hope this served as a good, "getting your foot wet" article. In a follow-up article, we'll look at the non-U.S. markets, specifically the Libor rates that are available through eSignal's services, as well as the forward curve and how it relates to the commodity markets.