How to improve your trading by looking at interest rates: Part 4

TVC:US01MY   US 1M yield
Hey everyone! πŸ‘‹

This month, we wanted to explore the topic of interest rates; what they are, why they are important, and how you can use interest rate information in your trading. This is a topic that new traders typically gloss over when starting out, so we hope this is a helpful and actionable series for new people looking to learn more about macroeconomics and fundamental analysis!

You can think of rates markets in three dimensions.

1.) Absolute
2.) Relative
3.) Through Time

In other words;

1.) How are rates traded on an absolute basis? AKA, do they offer an attractive risk/reward for investors?
2.) How are rates traded on a relative basis? AKA, what separates bond prices between different countries?
3.) How are rates traded through time? AKA, what is the "Yield Curve"?

In our first post, we took a look at how to find interest rate information on TradingView, and how rates fluctuate in the open market. In our second post, we took a look at some of the decision making that investors have to make when it comes to investing in bonds (rates) vs. other assets. In our third post, we took a look at rates on a relative basis between countries.

In today's final post, we'll be looking at how rates are traded through time - in other words, the Yield Curve. What information can you glean from looking at the Yield Curve? How can it help your trading plan? Let's jump in and find out!

For reference, let's first get a look at the Yield Curve:

This chart contains a couple different assets, so let's break them down quickly.

The white/blue area is the rate of interest you receive for 2 year bonds when you buy them
The orange line is the rate of interest you receive for 5 year government bonds when you buy them
The teal line is the rate of interest you receive for 7 year government bonds when you buy them
The yellow line is the rate of interest you receive for 10 year government bonds when you buy them
The purple line is the rate of interest you receive for 30 year government bonds when you buy them

As you can see, differing maturities for bonds pay different yields over time.

If you purchased a 2 year bond in early 2021, you'd be earning 0.15% yield PER YEAR.
At the same time, if you purchased a 30 year bond in early 2021, you'd be earning 1.85% yield PER YEAR.

The situation has changed since then. Currently:

If you purchase a 2 year bond, you're earning 3.56% yield PER YEAR.
if you purchase a 30 year bond, you're earning 3.45% yield PER YEAR.

In other words, the situation has completely flipped.

Why did this happen?

There are a few reasons, linked to many of the topics we discussed in the last few posts. Let's break them down.

1.) Central Bank Funds Rate risk
2.) Inflation Risk
3.) Credit Risk
4.) Market Risk

To start, from early 2021 to now, the central bank has raised the funds rate materially. This means that government bonds must see their yield increase. Why lend money to the government if you get more sticking your cash in a savings account?

Secondly, inflation has picked up. This has been a result of supply shocks across the globe for commodities & services. As shortages have cropped up and demand has been steady or increasing, increases in the price of everyday goods has led short term bonds to "Catch up" to the yields of longer maturity bonds.

Thirdly, as GDP has shrunk over the last two quarters, the risk that the U.S. government will be unable to pay back its debt through tax receipts and bond issuance rises.

Finally, as we said in the second post:

When stocks are outperforming bonds, institutional demand for stocks is higher, indicating that people are feeling good and want to take risk. When bonds are outperforming stocks, it can be indicative that people would prefer to hold 'risk free' interest payment vehicles as opposed to equity in companies with worsening economic prospects.

This demand for bonds plays out across the Yield Curve. Demand for 'risk free' assets increases as the economic outlook worsens, meaning that the Yield Curve is indicative of how market participants think the market situation will play out over a given period of time. If the yield for 2 year bonds is higher than 10 year bonds, then market participants through their purchases and sales are articulating that they expect the next two years to have more economic risk than the next ten. In other words, they expect some sort of economic slowdown.

This is extremely useful for multiple types of traders:

Equities are tied to the economy - if rates are saying something about economic prospects, then it's smart to pay attention, as it may inform your asset selection process / trading style
FX is intimately tied with rates - if rates are moving, FX is sure to be impacted.
Crypto has shown a high inverse correlation historically with the "ease of money" index. If rates are going up, then non-interest paying crypto becomes less attractive.

Anyway, that's all for our series on Interest Rates!

Thanks so much for reading and have a great rest of your weekend.

- Team TradingView ❀️

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