Watch Swaptions, Not the Yield Curve

Will it be long before business-oriented television programs start displaying the yield curve in the lower right-hand corner of the screen? There is so much else to hyperventilate over these days, what with gold back over $500, energy prices still troublesome, many stock indices behaving in a bullish manner and real estate either bubbling or de-bubbling, depending on the day the question is posed.

But as a Columnist Conversation last week confirmed, the yield curve is important in terms of access to capital. It was discussed again in this space just two weeks ago in the context of which industry groups were affected most. We have every reason to ask why a flattening yield curve, as defined by the spread between the 10-year and two-year Treasury notes, from almost 275 basis points on Aug. 13, 2003, to less than 8 last week, has not produced significant damage to the leveraged sectors of the economy. The answer is that swap rates have not risen to a damaging level; that factor, and not the yield curve, is critical.

Swap Rates

For all of the attention paid to the Federal Reserve's next move, an attention that should not be as necessary as it is, monetary policy does not directly affect the long end of the yield curve. This was always the case, but prior to the growth of financial derivatives, the Federal Reserve could choke off the supply of fixed-rate credit by raising short-term rates over banks' and savings and loans' interest rate ceilings.

As millions of American homeowners have discovered for better or worse in the mortgage market, derivatives allow credit to flow from willing lenders to willing borrowers. We can argue whether the surge in housing prices enabled by such innovations as interest-only or option adjustable-rate mortgages ultimately will be seen as a good thing or not, but the fact remains that no one was forced to participate in the mortgage market.

Corporate finance used to be dominated by such relative antiquities as bank loans and fixed-rate bonds. This has been shifting for years to floating-rate debt set against the swap rate.

The fixed rate in the swap market is set by the present value of the yield curve. Both borrowers and lenders price and hedge their swaps by buying and selling strips of three-month eurodollar futures on the Chicago Mercantile Exchange. If you buy the strip, you are lending at the strip's implied fixed rate; if you sell the strip, you are borrowing at the strip's implied fixed rate.

If you are looking for one of the reasons behind the tenfold increase in Chicago Mercantile Exchange Holdings'(CME Quote) stock price over the past three years, the 9.6-million-contract open interest in eurodollar futures might be a good place to start.

How have these swap rates moved since August 2003? At first, they fell on the order of 100 basis points going into March 2004. Then they shot higher by 140 basis points in just two months. That surge defined the trading range we have been in since May 2003.

The Yield Curve and Swap Rates

Source: Howard Simons

The Curve and Stocks

If long-term swap rates define the cost of capital and have remained in a trading range, then stock prices should benefit to the extent earnings grow and risk-aversion declines. If we map the yield curve spread plotted inversely against the Russell 3000, we see this to be the case.

The Yield Curve and Stock Prices

Source: Howard Simons

It would be difficult to argue from the chart above that the flattening yield curve has hindered stocks' ability to advance steadily against a number of other well-known headwinds. The Russell 3000's average annual total return of 14.61% over this period compares very favorably with the average annual total return of -11.66% during the September 2000-August 2003 period in which the yield curve steepened. Does anyone remember the absolute euphoria associated with the first rate cuts in 2001, especially the unexpected intermediate cuts in January and April? They were greeted as if the cavalry had just ridden into town.