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Discussion on the yield curve. Disclaimer: I’m no credit market expert. I’m an equity index derivatives trader who uses Treasury markets for signals and information, so this is by no means thorough.
Few points to keep in mind:
1) Yields move inversely to price
2) Federal Reserve (not the Fed Gov't) set the overnight interbank lending rate
3) Treasury rates are viewed as the risk-free rate, aka a baseline for taking risk
4) Interest rates represent the demand/supply of a currency
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Perhaps the most important: the 10yr. Old bond trader friend once told me that the 10yr is all you need to watch, and I’m a fairly big believer in that as well.
The 10yr is a bellwether for the market’s opinion/sentiment on the US economy and for good reason. Mortgage rates use the 10yr as a reference rate, equity markets use it to discount cash flows and price assets, commercial borrowers often get loans based on this rate, and generally it is thought of as the investor’s confidence in the US.
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For example: if the FOMC raises 25bps (already priced in before the meeting), and the 2yr during the press conference shoots up another 15bps, the market is reacting in excess of what was priced into the event. In such a case, the market intrepreted the contents press conference as more inflationary or the Fed itself as more hawkish (aggressive to raise rates). Why is a diferent story.
So the 2yr is useful for gauging the market’s immediate reaction to both Fed speak/meetings and economic data.
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The next important maturity is the 5yr
While not nearly as important, the 5yr is referenced by folks keeping an eye on inflation. The market’s expectation for inflation over the next 5yrs is called the 5-Year Breakeven Inflation Rate (see here: https://fred.stlouisfed.org/series/T5YIE), which is calculated by taking the 5yr Treasury rate minus the 5yr TIPS rate (Treasury Inflation Protected Security). This rate gives you the market’s expected inflation rate on average over the next 5 years.
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The 2yr bill and shorter durations are dictated by the Fed. Not literally, but since the Fed sets the front end rates (< 30 day), the 2yr bill reflects the Fed’s hiking/lowering plans for the next few years. This yield will react most on days with FOMC meetings or economic data, and therefore provides insight on how surprising said data was to the market.
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The yield curve itself starts with the 3 month Treasury bill rate and goes out to 30 years (even further with SOFR). These rates literally represent the amount of interest you will be paid if you buy a Treasury and hold it to maturity. However, the curve, individual yields, and spreads between durations represent the market’s opinion on various economic data/growth and sentiment.
This is the crux of my post: how to use the yield curve, it's components, and the yield spreads for signals and info
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The purpose of this post is to describe how I read/watch the Treasury yield curve for trading/investing signals and information.
When the Fed lowers/raises rates, they do this (now) by adjusting the overnight rate at which prime banks lend/borrow with one another. There’s tons of technical info about this (more here: https://twitter.com/concodanomics/status/1572379548653850625), but for our purposes just know that they set the < 30 day rates.
This is referred to as the "target rate."
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