In Part 2, I wrote that a long-term yield is roughly the average short-term rate the market expects over the bond’s life, plus a small term premium. I could repeat that sentence, but I didn’t really feel why it had to be true. Why would long rates already be high when the Fed has just cut short rates to almost nothing? Is it because people borrow more when the economy recovers? Are banks holding rates up?
This post works through the answer with numbers. Then it uses the same idea to explain why financial stocks are among the most cyclical in the market.
The choice every bond investor faces
Say you have $1,000 to invest for 3 years. You have two options:
- Lock it in: buy a 3-year bond and earn one rate for all 3 years.
- Roll it: buy a 1-year bond, and when it matures, reinvest in another 1-year bond at whatever the rate is then. Repeat for 3 years.
Now imagine the economy is at the bottom of the cycle. The Fed has cut the 1-year rate to 1%, but the market expects a recovery, and with it Fed hikes:
| Year | Expected 1-year rate |
|---|---|
| 1 | 1.0% |
| 2 | 2.5% |
| 3 | 4.0% |
If you roll, you reinvest everything each year:
- After year 1: $1,000 × 1.010 = $1,010.00
- After year 2: $1,010.00 × 1.025 = $1,035.25
- After year 3: $1,035.25 × 1.040 = $1,076.66
That’s the same as earning about 2.49% a year.
Now compare locking in a 3-year bond at different rates:
| 3-year rate | Value after 3 years | Compared with rolling |
|---|---|---|
| 1.00% (same as today’s short rate) | $1,030.30 | $46 worse |
| 2.49% | $1,076.66 | Same |
| 3.00% | $1,092.73 | $16 better |
At 1%, nobody would buy the 3-year bond: rolling beats it by $46. At 3%, everyone would want it. The only rate where nobody gains by switching is about 2.49%.
So the 3-year yield settles near 2.49% while the 1-year rate is still 1%. That’s a steep yield curve, and it comes entirely from where the market expects short rates to go.
How money flows push the yield there
No one has to set this rate. The market finds it.
Take a simple 3-year bond that pays $1,000 at maturity and nothing before (a zero-coupon bond). Its price is the $1,000 discounted at its yield:
- At a 1% yield: $1,000 ÷ 1.01³ = $970.59
- At a 2.49% yield: $1,000 ÷ 1.0767 = $928.80
Suppose this bond is trading at $970.59, a 1% yield. Investors can see that rolling 1-year bonds pays more, so they sell the 3-year bond and buy short bonds instead. Selling pushes the price down. A lower price means a higher yield. The selling continues until the price falls to about $928.80, where buying the 3-year bond and rolling pay the same.
It works from the borrower’s side too. If a company could borrow for 3 years at 1% while everyone expected rates to climb to 4%, that would be a bargain. Every company would rush to lock in long-term debt, and no lender would want to lend that way. Too many borrowers and too few lenders pushes the long rate up until locking in is no longer a free win.
Nobody coordinates any of this. Each investor and borrower picks the better deal, and the price adjusts until neither option is clearly better. Banks don’t set the 10-year yield; they price their loans off it like everyone else.
News moves long rates without the Fed doing anything
Now a strong jobs report comes out. The market decides the Fed will need to go further, and now expects the year-3 rate to be 5% instead of 4%. The Fed hasn’t changed anything, and the 1-year rate is still 1%.
- Rolling now gives: $1,000 × 1.010 × 1.025 × 1.050 = $1,087.01, or about 2.82% a year
- So the 3-year yield jumps from 2.49% to 2.82% in a day
- And the 3-year bond’s price falls from $928.80 to $919.95
This is why bond markets react so sharply to economic data. A single report changes the expected path of short rates, and long yields reprice immediately. It’s also why long rates usually start rising before the Fed hikes: they move as soon as the market expects the hikes.
Reading the yield curve backward
Because long rates price in where short rates are expected to go, the shape of the curve tells you what the market expects:
| Expected path of 1-year rates | Today’s 1-year | 3-year yield | Curve | What the market expects |
|---|---|---|---|---|
| 1% → 2.5% → 4% | 1% | 2.49% | Steep | Fed hikes, because a recovery is coming |
| 1% → 1% → 1% | 1% | 1.00% | Flat | No change |
| 4% → 2.5% → 1% | 4% | 2.49% | Inverted | Fed cuts, because a slowdown is coming |
The steep case and the inverted case have exactly the same 3-year yield. The only difference is the direction the market expects short rates to move.
The curve doesn’t measure growth directly. It reveals the expected path of the Fed, and the Fed follows growth and inflation. That’s why a steep curve is read as a forecast of recovery and an inverted curve as a warning of slowdown.
Isn’t it because people borrow more in a recovery?
That was my first guess, and it’s part of the story, but the timing shows it isn’t the main part.
At the very start of a recovery, actual borrowing is usually still weak. Companies are cautious and banks are careful about lending. Yet that’s exactly when the curve is steepest. If heavy borrowing were the main driver, the curve would steepen later, once borrowing picked up. Instead it steepens before the borrowing shows up. That points to expectations as the main driver.
Borrowing and growth do matter in two other ways, mostly later in the cycle:
- Real rates rise. Once the recovery is established, companies want capital to invest, and that competition makes money more expensive.
- Inflation expectations rise. A strong economy tends to push prices up. Lenders want to be paid for inflation eating into their fixed coupons, so they demand higher yields.
On top of all this sits the term premium: the small extra yield investors want for tying up money for longer and accepting more uncertainty. That’s why, in real markets, long rates are usually a bit above the pure average of expected short rates.
Two different “spreads”
The word “spread” causes a lot of confusion, because two different spreads move in opposite directions as growth picks up.
The term spread is the gap between long and short Treasury yields, often the 10-year minus the 2-year. It’s the slope of the yield curve.
- Early in a recovery it widens: the Fed holds short rates low while long rates price in the recovery.
- Later, when the Fed starts hiking, short rates catch up and it narrows (the curve flattens).
The credit spread is the extra yield risky borrowers pay over Treasuries. A common measure is the gap between Baa-rated corporate bonds and Treasuries.
- When growth improves it narrows: defaults look less likely, so investors accept less extra yield.
- In a downturn it widens sharply: investors demand more to lend to risky companies.
So in early recovery, the term spread widens while credit spreads narrow. Both are good news for one sector in particular: financials.
Why financials are cyclical
Banks, insurers, exchanges and investment banks don’t make things. They lend, insure, invest and arrange deals, so their profits depend on the economy more than you might expect. Four channels point the same way.
1. Loan volume. In an expansion, businesses borrow to expand and households take out mortgages and car loans. More loans means more interest income.
2. Net interest margin. Banks fund themselves mostly with deposits and short-term borrowing, which are priced off short rates. They lend through mortgages, business loans and bonds, which are priced off longer rates. The difference is their net interest margin, and a steep curve fattens it. Deposit rates also tend to lag behind Fed moves, which helps banks when rates first start rising. (Many loans float with short rates, so the curve isn’t the whole story, but it’s a big part of it.)
3. Credit losses. This is usually the biggest swing. In good times few borrowers default, and banks set aside little money for bad loans. In a recession, defaults jump and those losses come straight out of profit. This is why financials move with credit spreads: wider spreads are the market warning that defaults are coming.
4. Fees and asset prices. Investment banks earn on mergers, IPOs and bond issuance, which boom when confidence is high. Exchanges and brokers earn on trading volume. Wealth managers charge fees on asset values, and insurers earn on the bonds they hold. All of these rise in good markets.
Leverage turns small changes into big swings
Banks run on borrowed money. A bank might fund $100 of loans with $90 of deposits and only $10 of its own equity. That leverage means modest changes in income become large changes in the return to shareholders.
Here’s an illustrative bank in good times and in a recession (the numbers are made up for illustration, and the profit is before tax):
| Good times | Recession | |
|---|---|---|
| Interest earned on $100 of loans | 6.0% → $6.0 | 5.5% → $5.5 |
| Interest paid on $90 of deposits | 2.0% → $1.8 | 3.0% → $2.7 |
| Net interest income | $4.2 | $2.8 |
| Operating costs | −$2.0 | −$2.0 |
| Credit losses | 0.5% → −$0.5 | 2.5% → −$2.5 |
| Profit | $1.7 | −$1.7 |
| Return on $10 of equity | +17% | −17% |
Nothing in the recession column is extreme: a slightly narrower margin and a few more defaults. Yet the return to shareholders swings from +17% to −17%. That’s why bank stocks move more than the economy does.
Financials through the business cycle
In my portfolio management class, we use the Investment Clock, which splits the cycle into four phases based on whether growth and inflation are rising or falling. Here’s how global financials performed in each phase, according to BofA Merrill Lynch’s backtest (annualized returns, 1990–2010):
| Phase | Growth | Inflation | What the curve and credit do | Financials |
|---|---|---|---|---|
| Reflationary (early recovery) | Rising | Falling | Steep curve, credit spreads tightening | +23.4% |
| Inflationary (overheating) | Rising | Rising | Fed hikes, curve flattens | −1.6% |
| Stagflationary (slowing from the peak) | Falling | Rising | Flat or inverted curve, defaults start to rise | −13.1% |
| Deflationary (contraction) | Falling | Falling | Credit losses peak, Fed cuts | −9.9% |
The pattern matches the mechanics:
- Reflationary is the sweet spot. The curve is steep, defaults are falling, loan demand is picking up, and leverage magnifies all of it.
- Inflationary hurts because the Fed is hiking and the curve is flattening, squeezing margins. High inflation also tends to hurt financials.
- Stagflationary is the worst: the curve is flat or inverted, growth is rolling over, and defaults are starting to rise.
- Deflationary is still bad because credit losses peak, even though the Fed is cutting and setting up the next steep curve.
Not all financials are the same
The sector average hides real differences:
- Banks depend most on the curve and on credit losses. They’re the classic early-cycle play.
- Insurers invest the premiums they collect in bonds, so they earn more when yields rise. They behave more defensively than banks, because people keep buying insurance in a downturn.
- Exchanges and brokers earn on trading volume, and volume often rises when markets are volatile or when rates are uncertain. That makes them a partial hedge within the sector.
- Investment banks depend on deal activity, which is very sensitive to confidence and to stock prices.
Key takeaways from Part 3
- Investors can always lock in a long bond or roll short bonds. The long rate settles where those two choices pay about the same.
- So the long rate reflects the expected path of short rates, plus a small term premium. It moves as soon as expectations change, often before the Fed acts.
- A steep curve means the market expects the Fed to hike, usually because it expects recovery. An inverted curve means it expects cuts, usually because it expects a slowdown.
- The term spread widens early in a recovery, while credit spreads narrow. Both help financials.
- Financials are cyclical through loan volume, net interest margin, credit losses and fees, and leverage magnifies every one of them.
- In the Investment Clock backtest, financials did best in the Reflationary phase (+23.4% a year) and worst in the Stagflationary phase (−13.1%).