Clint Burdett Strategic Conslulting
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Market Risk - Liquidity Risk - Mania - CMTs - Yield Curve - Spreads <top> <Return to Risk>

A proxy for market risk is the end of the day, over-the-counter (OTC) bid price for Treasury securities (3 to 12 month Bills to 2 year Notes to 30 year Bonds). The New York Federal Reserve calculates these Constant Maturity Treasury (CMT) rates each trading day. Constant maturity is an adjustment for equivalent maturity made by the Federal Reserve Board to compute an index based on the average yield of various Treasury securities maturing at different periods.

This CMT yield curve for shows the yields today compared to the same period last year, how the yield is has changed over time. This example is from Value Line June 1, 2019 showing the 3m, 6m and 1 yr CMT spreads are inverted (darker line sloping down).

 

Yield Curve Example

The yield for security when sold is (face-value + remaining semi-annual interest payments to the buyer to maturity minus the sale price) divided by the face-value. Therefore yield will change at each sale. In a stable market CMT rates are index value where a 10 Yr Note with sold 18 months from maturity should have a lower yield for the buyer than for a buyer purchasing a 10 year note with 9 years to maturity. Shorter term CMT rates are normally lower than long term rates, the thin line in the example above. But if OTC buyers demand a higher yield for the shorter term CMTs, its price falls and the seller may sell at a loss to convert to cash.

The Federal Government sells its securities at auction to raise cash. Buyers of Federal securities pay more for a safe haven investment when the risk of market volatility is high (thereby decreasing their yield) or buyers pay less during predictable economic expansions (demanding higher yields at Treasury auctions). Then, individuals buy or sell those securities in the open market, which reflects daily the public's judgment on growth expectations versus market declines - (1) market risk. In normal times, shorter term yields are less (the OTC price is closer to the face value of the security - need the cash back sooner) than longer term yields (need the interest cash flow over time).

When the over-the-counter yields for CMTs converge, shorter term yields rise more (prices fall) than long term yields decline (prices rise), which I interpret as all investors are shifting assets to shorter terms. There is more uncertainty about making long term commitments, hence the CMT OTC yields are a proxy for market risk, liquidity risk (find a "safe haven"), and in the worse case risk of speculative mania (worry a "bubble will burst" - get out immediately or lose your investment).

Sellers in the open market get cash based on the immediate needs, which could be shifting cash to better investments , executing a plan, hedging against (2) liquidity risk by hoarding cash or short-term near cash investments - the" flight to safety," or needing cash now in a banking crisis (3) - sell securities save what you can mania.

During that 2007-2008 financial crisis, the TED spread was the measure of (4) credit risk, comparing very short term yields, the difference between the interest rate on short-term US government debt and the interest rate on interbank loans. In mania, you cannot get credit to borrow even short term and the government becomes the lender of last resort. Briefly in Seprember and October 2008, the mid and long borrowing commercial markets had essentially "shut down."

I have trouble getting my head around yield curve analyses. So I focus on spreads which compare CMT two yields from the 3, 6 month and 1, 5, 10, 30 year Treasury terms (spread = Yield A - Yield B): still too simple a measure for a very complicated economy but a technique to assess security buyers/sellers perception of risk.

 

The San Francisco Fed considers the 3m T Bill to 10 Year Note spread a slightly better leading indicator of a recession.

Chinn from Econbrowser discusses the 5yr - 3m spread (proxy for long-term assets purchases) as a leading indicator.

Hamilton from Econbrowser cautions reading too much into inverted yield curves, using a 3m-10 analysis.

 


Authored by Clint Burdett Strategic Consulting
A Practical Guide to Strategic Planning
©Arthur Clinton Burdett III- All Rights Reserved

All the data used to produce my graphs for my
observations on the economy are available to the
public from USA Government sources, use of which is
not protected by a copyright.

For St Louis FRED charts, see citation on the charts
or FRED page for the source and any restricted use.

All graphs indicate the data sources.

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