The Yield Curve and the Global Macro Investor

There are many global macro investing strategies that make use of the yield curve. While primarily used to trade bonds, there are also several good uses for trading stocks and currencies as well. In fact as powerful as the yield curve is, there is likely a few yield curve strategies for every asset class out there.

So what is the Treasury yield curve? It is the curve you get when you plot out the yields on different maturities of Treasury securities. For instance if you take the ninety day Treasury bill, the two year Treasury bill, five year Treasury note, ten year Treasury bond, and the thirty year Treasury bond you will get a curve. Usually sloping upwards from the bottom left to the upper right of the plot area, it can also take several other shapes. It can be very inverted with the far right down at the bottom and the far left at the top, it can have seemingly random lumps, and it can shift anywhere on the plot area. Each of these shapes and slopes of the yield curve tell the global macro investor something differently about the economy and the different trading instruments available to you.

This is great but how do you use it to make money? Well the global macro investor knows that if the curve is sloped from the lower left to the upper right that things are looking good for the economy. If on the other hand it is sloping downwards the Fed has tightened and the economy is or will be slowing.

So why does it work? Why does it matter what direction the yield curve is? Well if the yield curve is steep, going form the lower left to the upper right it means that banks are highly incentivized to lend money and therefore spur growth in the economy by helping businesses and individuals spend money on expansions as well as spending in general. This happens because when the curve is upwards sloping banks can borrow short term at low rates from the government and lend at higher rates for longer periods of time to the public.

If the curve is inverted however business is usually about to slow down, rates will be lowered, and bonds will climb. This is because with the incentive of the banks to lend now gone they will throttle back and the spigots of available money run dry. In turn this forces the Fed to lower short term rates, the Fed Fund rate, in order to spur business growth once again. When they lower rates bonds inevitably go up.

Think of bonds and interest rates as a teeter totter where yields are on one side and bonds are on the other. If bonds go down, rates go up. If rates go down, bonds are going up. In a regular inflationary environment this is always the case unless there is a severe credit quality issue.

If this is the case then anytime you can forecast the yield curve to show when the Fed will be lowering rates you can jump on it and go long bonds, typically with little risk. At the same time whenever you see rates being lowered you can wait a while and then go long stocks.

Of course as with all things in the market nothing works every time. In fact the quote history never repeats itself, but it often rhymes is a very appropriate statement. Used along with proper risk controls the yield curve can become one of the global macro investors best timing tools and economic gauges.