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Friday, July 07, 2006

Yield Curve Lessons Part I

Allez les bleus! The magic is back in team France as they face Luca Toni and the Italians in this year's World Cup Finals. A win by France would be the greatest win in history by a team most underrated coming into the finals.

After winning against Spain 3-1. "You have to congratulate the winning side but they weren't that much better than us." Luis Aragones, coach Spain

After winning against Brazil 1-0. "They were not better than us." Roberto Carlos, Brazil.

After winning against Portugal 1-0. "Portugal deserve to be in the Final more than France, and obviously I’m sad because our opponents took their only chance in the whole game." Fernando Meira, Portugal.

At this point, the French team are already winners.

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Is this the yield curve the US Fed is so concerned about? If that's the case then the Fed has to put more signs on the streets to warn us.

So what is so important about this yield curve?

The yield curve, in simple terms, is where all the possible rates of corresponding maturities of debt instruments lie. In this case, maturities of treasury bills with a tenure of 1 year to treasury notes of 10 yrs to 20 yrs(these long-term notes are also called bonds). This means, the Fed has debt instruments for public consumption either in the short term or the long term. They even have 90 day bills but even that has a different rate.

From the chart above, as you move from a 1 year tenured instrument to a 10 year tenured instrument, the corresponding rates move through the curve!

To better understand the movement of the yield curve, let's divide it into two parts: short-term and long-term. Short-term will have a range of 1 year to 5 yrs (cycles now are short, this is sometimes considered long-term). Long-term will have 10yrs and 20yrs.

Looking at the short-term rates, as you move from the 1 year instrument to the 5 year, the movement of the rates is steep. What does this mean? This means a higher rate is required by those who buy the instrument as maturity increases. The longer I hold the debt instrument, the more risk I assume, therefore the higher rate I would demand as a return.

The explanation on the long-term part is the same as the short-term but you wonder why the curve is almost close to flat rather than steep? The flattening of the long-term highlights the spread between the rate of the short-term vs. the long-term. The tightening spread is brought about by two things: (1) uncertainties of the future of the economy; (2) excess liquidity in the market.

First, the uncertainties. If a future slowdown of the economy is expected (which is accompanied by falling rates), then there is no point investing in a long-term instrument since the rates, are as expected, going to fall.

Second, excess liquidity in the market. You have to understand that such excess liquidity should go somewhere. Because investment intruments (risk-free at that) are limited, the excess liquidity can really crowd itself into that safe instrument and cause certain "abnormalities". Take note that the long-term instrument is like a bond wherein buying too much of it would cause its price to go up and cause its yield to go down. The sheik in the desert with his billions of petrodollars would not mind dumping all of his money into the long-term note as this instrument is "liquid"(in trader terms, it has volume and can absorb such demand). This is the safest haven for his billions. If he still has money left, some of it can go to Osama.

The abnormality that happens is the inversion of the yield curve wherein the long-term rate is lower than the short-term rate. More on the inverted yield curve in our next class!

Bryan

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