The yield curve & why it is important | Will the ADP report move the Forex market today?

It will be necessary to pay attention this morning because we will be writing about bonds and bond yields. The reason these are important is because short term yields have risen to levels that that they have not been at for many years, to the extent that the yield curve is flattening out. Last week the differential between the five year and thirty year bond yield was at its lowest since 2009 (see chart above).

This can only happen if fixed income investors are selling short term bonds. They would only be doing this if they felt that interest rates in the US have the potential to rise in the medium term. And we need to know about it because such a development is bullish for the US dollar.

When bonds are sold, the price goes down and the yield rises. This is because the yield is determined by the price of the bond in the secondary market related to its coupon rate, which is fixed for the lifetime of the bond (that is why bonds are known as “fixed income” investments).

The yield curve illustrates the progression in the amounts that an investor can collect by purchasing bonds of varying maturities. Because of the higher risk of inflation over a longer time period (and default if the instrument is not a US government, or Treasury, bond), an investor will expect a higher rate of effective interest for longer term paper. In those cases, which have cropped up from time to time, where the opposite is true and long term yields are lower, the yield curve is said to be “inverted”. This is regarded by economists as a harbinger of recession.

The connection with interest rates comes about because, at the present cost of money, it pays large institutions to borrow and use the cash to buy treasuries. They make on the difference between what they pay for the money and the treasury yield, and they also take no risk. Sovereign bonds are regarded as safe, and those of the US government as ultra-safe.

So if interest rates are perceived to be on the rise, or likely to be on the rise in the near future, it would pay those institutions to close out their positions in treasuries. They could then repay their loans, or they might look for opportunities elsewhere, perhaps in the Carry Trade, where loans are sought in low interest jurisdictions and re-lent in those where interest rates are higher. If these institutions are commercial banks, they might even start lending to small and medium sized businesses.

Or perhaps we are being just a bit fanciful with that last bit.

Will the ADP payroll report move the Forex market later today?

The private payrolls company, ADP inc., brings out its monthly employment report later today. This attempts to anticipate the official US government Non-Farm Payrolls report, which is on Friday.

ADP has had the ability to move the Forex markets in the past. However, there are two reasons why it may not do so on this occasion: One, the Federal Reserve has let it be known that it will take many more economic indicators into account when formulating policy, as opposed to solely relying on employment statistics as it has been doing and two, the fact of the matter is that, for one reason or another, the ADP report has failed on a number of recent occasions to even come close to predicting what the official report will contain. This has affected its credibility.

Notwithstanding the above, we have instructed the Mandelbrot routine to take half of our USDJPY position off the table. We cannot foretell the future, our position has attained better than 2% of equity as profit (2.4% to be exact) and the Dollar Yen pair looks like it might have reached a level where there is likely to be some resistance (see chart above). Safety first.