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The Story from Interest Rates

The fixed income markets are incredibly large.  According to the Bank for International Settlements, as of 2009, the world bond market stood at $82 trillion which was about twice as big as the global equity market.  Even though bonds may not seem like sexy instruments, they can relay plenty of information that is often overlooked by equity investors.  The simple truth is that the world is controlled by interest rates.  Governments, companies and individuals borrow at prevailing interest rate levels.  If yields are low, then borrowing costs are low and stimulate investment (as long as banks are willing to lend).  What has happened since the beginning of the European “crisis” has been a continuous decline in interest rates across all tenors.

The two year yield at .629% is making all-time Lows

With the two year government yield hitting an all-time low of .629%,  the two year treasury is relaying a bevy of information.  The most blatant observation is that the market believes that the federal reserve will keep its extremely accommodative monetary policy throughout 2010 and probably through 2011.  This means that “free money” will be available in the economic system for the foreseeable future.  The second observation is that the markets will not experience inflation and could perhaps indicate that we should expect to experience deflation.  As a follow-up effect to the first two observations, if the fed is not expected to raise short-term interest rates and inflation is expected to be low, then we should expect very low growth levels and a slow recovery in employment levels.

The two year treasury yield leaves us with depressing news.  What provides me with a glimmer of hope is the continued steepness in the yield curve.  Even though the two year rate has declined from 1.17% on April 5th to .629% today (54 bps decline), the steepness of the yield curve between the ten year treasury and the two year treasury has declined 42bps.  This might not seem like much of a change, but if the two year expects doom and gloom, then I would expect that the ten year and thirty year would price in the long-term Japanese deflationary scenario.

The Ten Year Two Year spread still remains historically high which is usually a bullish signal for asset prices

You might think that I am grasping at straws, but a steep yield curve is usually a very healthy signal.  It generally shows that future expectations for growth and/or inflation are much higher than they are today.  With the current 5 year treasury yielding 1.83% and the 10 year treasury yielding 3.02%, the yield curve is telling us that the 5 year interest rate in 5 years must be 4.44%.  A 5 year rate at over 4% would indicate anything but a Japanese outcome.  Aside from signaling, the current yield curve is providing plenty of opportunity to make money.  Just think of it this way:  If you can borrow at .629% and invest in a five year bond at 1.83%, how can you lose money?  The banks do not even have to think about that miserable return because they can lend to home owners at 4.75% for a 30-year mortgage.  That 30-year mortgage at 4.75% allows a first-time buyer to afford a house or it allows someone to refinance and save a large amount of money in interest per year which they can use to stimulate the economy.  The current interest rates are very conducive for a recovery and let us all hope that we can get this engine started once again.  After that, we can start worrying about how we will pay for it all.

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6 Responses

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  1. Brendan says

    Thanks for the insights.

    On another note, I’m excited about the new exchange-traded options on ETNs like AMJ and especially VXX. Any chance you’d consider devoting a future post re. trading ideas with options on VXX (I like the collar pricing right now but as a novice I’d respectfully defer to your viewpoints on skew and such like). Thank again, and take it easy.

  2. SurlyTrader says

    Brendan –

    I have yet to look at how the VXX and VXZ options are pricing, but I have spent quite a bit of time trading VIX futures options so I assume they are similar. I will take a look at it in the next few days and be sure to provide my opinion.


  3. Brendan says

    Looking forward to learning more–thank you!

Continuing the Discussion

  1. Tuesday links: flight-to-safety Abnormal Returns linked to this post on June 29, 2010

    […] yield on the 10 year note drops below 3.0%.  (Crossing Wall Street, MarketBeat, SurlyTrader, Barron’s, Credit […]

  2. Six Days of Nonsense | SurlyTrader linked to this post on July 7, 2010

    […] Looking specifically at the level of interest rates, I might become quite bearish, but looking at the steepness of the curve gives me a little more hope. […]

  3. What Vol and the Dollar Have in Common | SurlyTrader linked to this post on November 4, 2010

    […] If you have been a reader, you would know that I have been shorting VIX futures in different forms.  At 35% I thought it was crazy expensive and now it is more fairly priced.  Pretty soon it will probably be extremely cheap.  Volatility is linked to stock prices and liquidity.  If asset managers are chasing yield, risky assets, or any returns greater than a zero percent overni…. […]

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