- What is the yield curve?
- What does it mean when it’s inverse?
- What is Yield Curve Control (YCC)?
- And how does the Eurodollar fit into all this?
Inspirational Tweet:
As Lyn Alden explains in this thread: “…The 10-2 curve says, “It is possible that we are approaching a potential recession, but it has not been confirmed, perhaps after several months…“
Let’s break that down a bit, shall we?
What is the yield curve?
First of all, what exactly is yield curve Everyone seems to be talking about it lately, and how does it relate to inflation, the Federal Reserve and a possible recession?
The yield curve is basically a graph that plots all the current nominal rates (not including inflation) for each government bond. maturity is a bond term, and fruit It is the annual interest rate that the bond will pay to the buyer.
Normally a normal yield curve diagram (this one from 2018) looks like this:
The Federal Reserve sets the so-called Federal Funds Rate, and this is the shortest interest rate you can get, since it is the (annual) rate that the Federal Reserve proposes commercial banks to borrow and lend their excess reserves to each other overnight. This rate is the standard by which all other rates are priced (or so, in theory).
You see, in a normal economic environment, the shorter the maturity of a bond, the lower the yield. This is quite logical in that the shorter the time allotted to lend to someone, the less interest you will charge them for the agreed closing period (duration). So how does this tell us anything about future economic downturns or possible recessions?
This is the place Inversion of the yield curve It comes into effect and what we’ll address next.
What does it mean when it’s inverse?
When a short-term bond, such as 3 months or 2 years, begins to reflect a higher yield than a long-term bond, 10 years or even 30 years, we know there is a potential problem on the horizon. Essentially, the market tells you that investors expect prices to be lower in the future due to an economic slowdown or recession.
So, when we see something like this (eg, August 2019):
Source: FRED®, Federal Reserve Bank of St. Louis
…where 3-month and 2-year bond yields yield more than 10-year bonds, investors are starting to get nervous.
You will also sometimes see it expressed as below, showing the actual difference between 2-year and 10-year interest rates. Notice the August 2019 intraday reversal here:
Source: FRED®, Federal Reserve Bank of St. Louis
Why does it matter so much, if it’s just a file indication Isn’t it real yet?
Because the reversal not only shows an expected slowdown, it can wreak havoc on the lending markets themselves and cause problems for businesses as well as consumers.
When short-term rates are higher than long-term rates, consumers with adjustable mortgages, home equity lines of credit, personal loans and credit card debt will see payments rise due to higher short-term interest rates.
Also, profit margins are lower for companies that borrow at short-term rates and lend at long-term rates, such as many banks. The collapse of this spread leads to a sharp decrease in their profits. So they are slightly less willing to lend, and that only leads to continued borrowing problems for many consumers.
It’s a painful feedback loop for everyone.
What is yield curve control?
It’s no surprise that the Federal Reserve has an answer to all of this – has it always? in the form of what we call Yield Curve Control (YCC). This is basically the Fed setting a target level for rates, then entering the open market and buying Short-term papers (one to two-year bonds, usually) and/or Sell Long-term securities (10-30 year bonds).
Buying lowers interest rates on short-term bonds, and selling increases interest rates on long-term bonds, normalizing the curve to a “better” state.
Of course, there is a cost to all of this with the potential expansion of the Fed’s balance sheet and further expansion of the money supply, especially when the open market is not engaged at the level needed for the Fed to achieve its target rates.
calendar? Potential exacerbating inflation, even in the face of a contracting economy. which is what we call Inflation accompanied by economic stagnation. Unless curve control helps avert a pending recession and resume economic expansion: a big IF.
What is the Eurodollar and how does it fit into all this?
Eurodollar bonds are US dollar-denominated bonds issued by a foreign company and held in a foreign bank abroad Both The United States and the country of origin of the issuer. a bit baffling, like the prefix”euro” It is a comprehensive reference for all foreign companies and banks, not just European companies and banks.
Most importantly, and in our context here, the Eurodollar futures It is a forward contract based on the interest rate on Eurodollars, with a maturity of three months.
Simply put, these futures contracts will be traded in the market expect US interest rate levels will be 3 months in the future. It is an additional data point and an indicator of when the market expects interest rates to peak. (This is also known as Final rate from the Federal Reserve cycle.)
For example, if the EUR/USD contract in December 2023 shows an implied rate of 2.3% and rates drop to 2.1% in the March 2024 contract, then the expected peak for the fed funds rate will be at the end of 2023 or early 2024.
That simple, and just another place to look for clues as to what investors think and expect.
What You Can Do About It… (Yes – Bitcoin)
Let’s say you watch prices closely and hear that the Fed is going to start using the YCC to run the rate curve, thus printing more money and, therefore, likely to cause more inflation in the long run. And what if inflation somehow gets out of control? How can you protect yourself?
It doesn’t matter when you read this, as long as the world is still primarily run with (government-issued and “subsidized”) money, bitcoin remains a hedge against inflation and an insurance against hyperinflation. I wrote a simple but comprehensive thread about it here:
To identify the attributes of inflation hedge in Bitcoin, it is really simple. Since Bitcoin is governed by a mathematical equation (not a board of directors, CEO, or founder), the supply of Bitcoin is completely limited to 21 million.
Moreover, with a truly decentralized network (computers collectively governing the Bitcoin algorithm, mining and transaction settlements), stable transactions and the total number of bitcoins to be minted will never change. Thus, Bitcoin is immutable.
In other words, Bitcoin is safe.
Whether the Bitcoin (BTC) price is volatile or not in the short term does not matter as far as we know that the value of the US dollar continues to decline. And in the long run and in aggregate, as the dollar goes down, BTC goes up. So it is a hedge against long-term inflation not only for the US dollar, but any fiat currency issued by the government.
The best part? Each single bitcoin consists of 100 million “pence” (actually the smallest unit of bitcoin – 0.00000001 btc – called satoshis, or sats), so one can buy as much or as little as they can or want in a single transaction.
$5 or $500 million: You name it, Bitcoin can handle it.
This is another guest post by James Lavish. The opinions expressed are their own and do not necessarily reflect the opinions of BTC Inc or Bitcoin Magazine.