Why The 2s & 10s Yield Spread Matters
The 2s and 10s yield spread is a very handy chart if you know what to look for and how to use it in your trading. We take you through how to use it in this video…
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We’ve been getting quite a few questions in the Q&A after a few of our videos today referred to the 2s and 10s yield spread, with the majority of the questions asking what exactly is the 2s and 10s spread, how can we view it and how can we use it in our trading?
All great questions so let’s jump into them straight away by looking at the first one which is what exactly is the 2s and 10s yield spread. So, if I open up a chart of the 2s and 10s spread, and we go to a higher timeframe like the weekly, you can see that the chart tends to move like a sine curve, and these sine waves usually follows the overall growth cycle of the US quite well.
It’s basically just the US10Y bond yield minus the US02Y bond yield, and when the spread is moving higher, or also known as curve steepening, it simply shows that longer-dated bond yields (in this case the 10Y’s) are higher than shorter-dated bond yields (in this case the 2Y’s), and when the curve is moving lower, also know as curve flattening, it simply shows that longer-dated bond yields like the 10’s are lower than the shorter-dated bond yields like the 2’s.
So, why is curve steeping, or a move higher in the spread important, and why is curve flattening, or a move lower in the spread important? Well, historically, an inverted 2s and 10s yield spread, meaning it dips below 0, has been one of the most accurate predictors of recessions in the US. There have been a few false alarms, but generally, it’s been one of the most accurate anticipators of incoming recessions, by being accurate enough to prelude the past 7 recessions if I recall correctly.
Why does the curve steepen or flatten in the first place? Well, it all comes down to market expectations about monetary policy, in this case expected policy changes from the FED. Remember, that short-term and longer-term risks are priced into markets well ahead of those risks actually materialising.
So, what you usually see is that the curve tends to steepen just before or during the actual recession. Now the reason explained by people much smarter than me says this is because the FED is usually behind the curve, which means rates are cut a tad too late which means the cuts aren’t enough to stop the recession, the curve simply front-runs the expected cuts and then as they start to transpire the curve steepens as rates are cut and expectations for longer-dated yields move higher than shorter-dated yields, and then the expected recession finally hits.
So, coming back to what we are seeing now, is this the steepening before the recession? In true market talk, this time might be different. Remember, the speed of this recession and downturn has been one of the fastest, if not the fastest on record, and central banks like the FED, seeing the problems that are ahead, threw in the kitchen sink to try and save their economies from the downturn.
Also remember, that the yield curve already inverted before covid was on the scene, so a recession was expected and have already taken place in Q2. So, right now, the steepening, in my honest and humble opinion, is not a prelude to a recession because we just came out of it. I think this steepening we are seeing is the market seeing that the short-term risks have subsided as positive vaccine news calms the nerves, basically showing a reduction of the short-term risks, requiring less yield for holders of shorter-dated bonds and meaning more yield require by investors holding longer-dated yields.
So, like we’ve been highlighted for a while now, the market expects the global economy to recover going into 2021, and one of the big factors in that expectations is having a vaccine, so the curve is steepening for the right reasons in terms of the economic outlook.
And, then the final question, how you can view this, well I just view it on tradingview. To get it is quite simple, on any chart just open up the search, and type in US10Y-US02Y, now don’t wait for it to search it because it won’t give you anything, after typing that in just hit enter and it will open the chart for you.
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If you find this content helpful, you’ll love Financial Source.
There’s a link below were you can learn more about it
https://financialsource.co
----
We interpret and explain price moves in real-time, 24 hours a day. Our team of analysts produce text, video and audio commentary.
You understand the markets and trade with confidence. Learn more at our website here: https://financialsource.co
-----
We’ve been getting quite a few questions in the Q&A after a few of our videos today referred to the 2s and 10s yield spread, with the majority of the questions asking what exactly is the 2s and 10s spread, how can we view it and how can we use it in our trading?
All great questions so let’s jump into them straight away by looking at the first one which is what exactly is the 2s and 10s yield spread. So, if I open up a chart of the 2s and 10s spread, and we go to a higher timeframe like the weekly, you can see that the chart tends to move like a sine curve, and these sine waves usually follows the overall growth cycle of the US quite well.
It’s basically just the US10Y bond yield minus the US02Y bond yield, and when the spread is moving higher, or also known as curve steepening, it simply shows that longer-dated bond yields (in this case the 10Y’s) are higher than shorter-dated bond yields (in this case the 2Y’s), and when the curve is moving lower, also know as curve flattening, it simply shows that longer-dated bond yields like the 10’s are lower than the shorter-dated bond yields like the 2’s.
So, why is curve steeping, or a move higher in the spread important, and why is curve flattening, or a move lower in the spread important? Well, historically, an inverted 2s and 10s yield spread, meaning it dips below 0, has been one of the most accurate predictors of recessions in the US. There have been a few false alarms, but generally, it’s been one of the most accurate anticipators of incoming recessions, by being accurate enough to prelude the past 7 recessions if I recall correctly.
Why does the curve steepen or flatten in the first place? Well, it all comes down to market expectations about monetary policy, in this case expected policy changes from the FED. Remember, that short-term and longer-term risks are priced into markets well ahead of those risks actually materialising.
So, what you usually see is that the curve tends to steepen just before or during the actual recession. Now the reason explained by people much smarter than me says this is because the FED is usually behind the curve, which means rates are cut a tad too late which means the cuts aren’t enough to stop the recession, the curve simply front-runs the expected cuts and then as they start to transpire the curve steepens as rates are cut and expectations for longer-dated yields move higher than shorter-dated yields, and then the expected recession finally hits.
So, coming back to what we are seeing now, is this the steepening before the recession? In true market talk, this time might be different. Remember, the speed of this recession and downturn has been one of the fastest, if not the fastest on record, and central banks like the FED, seeing the problems that are ahead, threw in the kitchen sink to try and save their economies from the downturn.
Also remember, that the yield curve already inverted before covid was on the scene, so a recession was expected and have already taken place in Q2. So, right now, the steepening, in my honest and humble opinion, is not a prelude to a recession because we just came out of it. I think this steepening we are seeing is the market seeing that the short-term risks have subsided as positive vaccine news calms the nerves, basically showing a reduction of the short-term risks, requiring less yield for holders of shorter-dated bonds and meaning more yield require by investors holding longer-dated yields.
So, like we’ve been highlighted for a while now, the market expects the global economy to recover going into 2021, and one of the big factors in that expectations is having a vaccine, so the curve is steepening for the right reasons in terms of the economic outlook.
And, then the final question, how you can view this, well I just view it on tradingview. To get it is quite simple, on any chart just open up the search, and type in US10Y-US02Y, now don’t wait for it to search it because it won’t give you anything, after typing that in just hit enter and it will open the chart for you.
-----
If you find this content helpful, you’ll love Financial Source.
There’s a link below were you can learn more about it
https://financialsource.co
