Bond Market - Forecaster of Economic and Risk Conditions?
Many view bond market performances as one of the leading indicators of future economic and risk conditions. Historically, the performance of the US yield curve and the performances of key US treasury yields tend to reflect investor expectations of future economic conditions and risk levels approximately 6 to 12 months out. That is investors tend to anticipate the future when making current investment decisions. So, at any given point in time, the bond prices and the shape of the US yield curve are discounting the market consensus views of economic conditions of what is to come.
The bond market is not always right. However, bond investors as a group are noted to be informed or experienced investors, and because of the conservative nature of their investments (i.e., fixed income instruments), the bond investors are less likely to speculate and to take excessive risks in the marketplace.
For that reason, the long-term bonds have had a strong track record as a forecaster of future economic and risk conditions. It continues to be widely followed by economists, strategists, portfolio managers, and many institutional and retail investors. If nothing else, the performances of the bond market can act as a gauge of the consensus expectations regarding the state of the economy – even if that expectation sometimes proves to be incorrect.
With the above thoughts in mind, we have provided you with the yield curve of key US bonds of varying maturities – from short-term maturities such as the 1-mo and the 3-mo to as long-term maturities such as the 10-year, 20-year, and 30-year. It is important to understand the intricate relationships and the performances of the different maturities. The shorter-term yields of maturities of two years or less tends to track the expectations of future Fed’s rate policy via the federal funds rate. In contrast, the performances of the more volatile and longer-term maturities, which are typically driven by the outlook for future inflation and economic growth more so than by Fed policies. Expectations for the economy tend to be one of the primary drivers to the shape of the US yield curve.
When the yields on the long-term bonds rise faster than the short-term bonds or when long-term bond prices are underperforming short-term bond prices then the yield curve tends to steepen. This conveys an economic environment in which investors expect strong or improving economic growth in the future. On the other hand, when the yields on short-term bonds are rising faster than the yields on the long-term bonds then the yield curve tends to flatten. This is often an indication of investors expecting slower growth ahead. The US yield curve can sometimes invert when the short-term bond yields are higher than the long-term bond yields. Under this scenario, investors expect the economy may be slowing or contracting toward a possible recession or worse, expecting a financial market crisis (risk-off condition).
Can the bond market send out false signals about the economy and risk conditions?
Yes, the yield curve is not always accurate. This is especially true when the Fed intervenes in the marketplace during the global financial crisis of 2007-2009 and the most recent Feb-Mar 2020 COVID-19 pandemic. The massive bond-buying program such as quantitative easing (QE) by the Fed can skew the supply and demand equilibrium of the long-end of the yield curve and impact the performances of longer-term maturities.
Another important factor to remember is US bonds and the yield curve can sometimes be affected by a change in investors’ risk appetites. When investors grow increasingly nervous about the financial markets or about the economy the flight to quality away from higher-risk assets to the longer-term bonds can cause the shape of the yield curve to change toward a flatter or even to an inverted yield curve under the extreme market risk-off scenario.
In conclusion, investors and traders need to keep an eye on the slope of the US yield curve and on the performances of US bond yields especially the longer-dated US maturities (10-year, 20-year, and 30-year) this is only one tool, albeit an important one. However, one should also take the signals with the appropriate grain of salt when the Fed and central banks are actively involved in the financial marketplace.