If you invest in equities, you should keep an eye on the bond market. If you invest in real estate, you should keep an eye on the bond market. If you invest in bonds, you should definitely keep an eye on the bond market. The bond market is a great predictor of future economic activity and future levels of inflation, both of which directly affect the price of everything from stocks, real estate, commodities to household items.

The yield curve can also be a precursor of trouble ahead, such as the inverse yield curve prior to the US market correction in January 2008 (read more below). Interestingly, there's a similarity between the US yield curve back then to the Aussie yield curve today. Does this suggest that a downturn for the Australian economy is in the wings? 

Important components of the yield curve

Interest rates and bond yields are highly correlated, and sometimes the terms are used interchangeably. An interest rate might be thought of as the rate at which money can be borrowed in the form of a loan and, while most bonds have an interest rate that determines their coupon payments, the true cost of borrowing or investing in bonds is determined by their current yields.

A bond's yield is simply the discount rate that can be used to make the present value of all of a bond's cash flows equal to its price. A bond's price is the sum of the present value of each cash flow that will ever be received from the investment.  

When speaking of interest rates (or yields), it is important to understand that there are short-term interest rates, long-term interest rates and any number of points in between. While all interest rates are correlated, they don't always move in step. For example, short-term interest rates might decrease, while long-term interest rates might increase, or vice versa.

Short-term interest rates worldwide are administered by the nations' central banks. The RBA's Open Market Committee (FOMC) sets the official cash rate, the benchmark for other short-term interest rates. The FOMC raises and lowers the official cash rate as it sees fit to promote or curtail borrowing activity by businesses and consumers. Borrowing activity has a direct effect on economic activity. If the FOMC finds that economic activity is slowing, it might lower the official cash rate to increase borrowing and stimulate the economy. However, the FOMC must also be concerned with inflation. If the FOMC holds short-term interest rates too low for too long, it risks igniting inflation by injecting too much money into an economy that is chasing after fewer goods.

While short-term interest rates are administered by central banks, long-term interest rates are determined by market forces. Long-term interest rates are largely a function of the effect the bond market believes current short-term interest rates will have on future levels of inflation. If the bond market believes that the FOMC has set the official cash rate too low, expectations of future inflation increase, which causes long-term interest rates to increase in order to compensate for the loss of purchasing power associated with the future cash flows of a bond or the principal and interest payments on a loan. On the other hand, if the market believes that the FOMC has set the official cash rate too high, the opposite happens - long-term interest rates decrease because the market believes future levels of inflation will decrease.   

Reading the Yield Curve

The term "yield curve" generally refers to the yields of Australian Treasury bills, notes and bonds in sequential order from shortest maturity to longest maturity. It is frequently displayed graphically. With the understanding that the shorter the maturity, the more closely we can expect yields to reflect (and move in lock-step with) the official cash rate, we can look to points farther out on the yield curve for a market consensus of future economic activity and interest rates. Below an example of the yield curve at present.

Source: Bloomberg

The slope of the yield curve tells us how the bond market expects short-term interest rates (as a reflection of economic activity and future levels of inflation) to move in the future. This yield curve is "inverted on the short-end" and suggests that short-term interest rates will move lower over the next two years, reflecting an expected slow down in the Australian economy. As you can see in the table 10-year Australian Government bonds are below 1-year bonds.

A normal yield curve would graph higher long-term interest rates than short rates. That's becuase there's a greater risk from investing funds for 10 years than for a year or so. However, sometimes this relationship goes topsy-turvy, with short-term rates exceeding long yields. Because this is unusual (though far from unprecedented), an inverse yield curve can sometimes be viewed as a cause of concern. It can signal recession.

A similar yield curve was spotted in 2008 just before the US economy moved into recession. The graph below is the US bond yield curve at the start of the US sharemarket downturn in January 2008.

Interestingly, BRICs player Brazil has an inverse yield curve, which also resembles the US just before its market capitulated (see below).

Note: Using the above yield curve for the Australian bond market as an example, it should not interpreted that the market believes that two years from now the short-term interest rates will be 3.55% (the two-year yield as shown above). There are other market tools and contracts that more clearly show a "predicted" future rate of a benchmark like the official cash rate. The yield curve is best used to make general interest rate forecasts, rather than exact predictions.

Use the Yield Curve to Help Make Top-Down Investment Decisions

Interpreting the slope of the yield curve is a very useful tool in making top-down investment decisions. For example, if you invest in equities, and the yield curve says to expect an economic slowdown over the next couple years, you might consider moving your allocation of equities toward companies that perform relatively well in slow economic times, such as consumer staples. On the other hand, if the yield curve says that interest rates are expected to increase over the next couple of years, an allocation toward cyclical companies such as luxury goods makers or entertainment companies makes sense.

If you invest in real estate, you can use the slope of the yield curve to help in your investment decisions. For example, while a slow-down in economic activity might have negative affects on current real estate prices, a dramatic steepening of the yield curve (indicating an expectation of future inflation) might be interpreted to mean future price will increase. Remember, timing is everything.

You could even use the slope of the yield curve to help you decide if it's time to purchase that new car. If economic activity slows, new car sales are likely to slow and manufactures might increase their rebates or other sales incentives.

Conclusion

Bond market studies shouldn't be left to just the fixed-income investors. The yield curve can help make a wide range of financial decisions. The yield curve reflects the bond market's consensus opinion of future economic activity, levels of inflation and interest rates. It's very difficult to outperform the market, so prudent investors should look to employ valuable tools like the yield curve whenever possible in their decision-making processes.

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