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How the Market Works

Yield Spread Is More Useful Than You Think: How the Market Works

Posted by kdadmin on February 28th, 2017.

Yield Spread Is More Useful Than You Think: How the Market Works

Have you ever felt ignorant when you watched the financial news? Let me help you.

There are several bits of financial news that allow me to get a picture of how the global markets are trending in five minutes. Yield spread is one of them. Recessions are another (grey bars). Yield spread is a common metric rattled off by daily financial news briefings. If you know what it means, and you listen for it, you can learn how to understand market the market in five minutes too.

Yield Spread is More Useful Than You Think

Yield spread refers to the difference in yields between two bonds. Because different bonds, of different terms (maturities), interest rates and credit worthiness, change in different ways, for different reasons; the spread between the two can tell you a lot about market sentiment and likely future trends.

For example, the 2 Year Treasury Yield is closely tied to expected changes in Federal Reserve policy. It goes up with a rising federal funds rate and down with a falling federal funds rate.

Whereas the 10 Year Treasury Yield is somewhat affected by Fed policy, but is also largely affected by other metrics like economic growth (GDP), supply and demand of the bonds themselves, the inflationary outlook, and the market’s general appetite for risk (as in riskier, more volatile investments like stocks). Broadly speaking, 10 Year Treasury Yields:

  1. Fall when economic growth (i.e. GDP) is low, inflation is low, and when the market’s attitude towards risk is low. (Because investors flee to the safety of these bonds, driving up bond prices, which move inversely to yields.)
  2. Rise when economic growth is escalating, inflation is rising, and the market’s appetite for risk is high. (Because investors will return to the more lucrative returns of stocks, causing bond prices to fall, thereby driving up yields.)

If both the 10 year and 2 year treasury are influenced by the federal funds rate, but only the 10 year is really influenced by outside market factors like GDP growth, inflationary outlook, and the market’s opinion of risk; then linking them in a spread provides a way to look at the broad market while adjusting for movements in the federal funds rate without ignoring the federal funds rate.

In other words, the spread allows you to understand where the market is going based on how it has anticipated various economic indicators.

Why Do You Care?

Year_Treasury_Yield_Spread_vs_Unemployment_Rate

If the spread between the 10 year treasury and the 2 year treasury is rising, it typically means the market in general is in a growth mode with a higher appetite for risk (out of bonds into stocks).

If the spread between the 10 year treasury and the 2 year treasury is falling, it typically means that the market is in a contraction mode with a lower appetite for risk (out of stocks and into bonds).

In fact, in every one of the recessions the last fifty years, the 10-2 year treasury yield spread has fallen sharply right before it. Notice the grey bars in the chart above. Those are all recessions.

What else has falling sharply right before every market correction in the last fifty years? The unemployment rate. Notice how the unemployment rate and the 10-2 year treasury spread have both moved in sync and have both warned of coming recessions? Read more the unemployment rate in my article, “Hi, I’m Full Employment: How the Market Works.”

So, what do you think the market is trying to tell you about its appetite for the risk? And about its future appetite for riskier, more volatile investments?

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