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Mostly, the yield curves are upward sloping, however, based on the demand and supply forces, the shape of the yield curve changes. In a situation of high demand and limited supply, the yields (rate of return) can be expected to be low. However, the opposite holds true for low demand and limited supply, which could result in higher yields.
In the FOMC meeting last week, the Fed maintained their stance on the monetary policy despite a fall in the economic data since the committee met last in January 2014. The committee said it will continue the tapering as scheduled, which means another $10 billion cut in the asset purchase is expected in April 2014. This would reduce the bond purchases going forward to $55 billion a month from $65 billion a month. The Fed’s chairwoman, Janet Yellen indicated that the first Fed funds rate hike could come in roughly six months after the Fed finishes the bond-purchase program, scheduled for a wind up in October or November 2014.
Normal Treasury yield curve
As observed in the chart above, at present the U.S. Treasury yield curve is “normal” meaning that yields rise as maturity lengthens (that is, the slope of the yield curve is positive). This positive slope reflects investor expectations for the economy to grow in the future, and importantly, for this growth to be associated with a greater expectation that inflation would rise in the future rather than fall.
At present the inflation rate in the U.S. is 1.1%. In the recent FOMC meeting conducted on March 18-19, 2014, the FOMC kept the PCE inflation rates unchanged, which is expected to grow at 1.6% by the end of 2014 and is expected to reach 2.0% by 2015—the threshold set by the Fed to start raising the Fed funds rate.
Yield and price roll down
Changes in the yield (rate of return) and the bond prices are a very important value driver of the bond market, particularly the Treasury bonds (TLT). When the interest rate rises, the bond price falls, and the yield increases. However, when the interest rate decreases, the bond price increases, and the yield falls. Investors mostly price expectations of increase in inflation and time value of future cash flows risks into the yield curve by demanding higher yields for maturities.
Last week, the Treasury yields mostly across the maturity spectrum (from one-year to 10 years) increased on the expectation of increase in the interest rate with the onset of tapering. Only the U.S. six-month (SHY) and 30-year Treasury (TBT) were slightly down than the previous week, while the ultra short government Treasury bills (BIL) were unchanged.
The U.S. ten-year Treasury yield (TLT)—an important barometer for fluctuations in the bank lending and mortgage rates—was up by 9 basis points to 2.74% compared to the previous week’s 2.69%.
In conjunction to the rise in the Treasury rates, the prices for T-bills, T-notes and T-bonds were down.
The next part of the series discussed how an investor can access the U.S. Treasury market to benefit from the weekly issuance and fund flow movement in the securities.
© 2013 Market Realist, Inc.