Question

How does yield spread relate to each of these: equity prices, inflation, GDP.

Answer 1

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A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuer, or risk level, calculated by deducting the yield of one instrument from the other. This difference is most often expressed in basis points (bps) or percentage points.

Yield spread relate to each of these : equity prices, inflation, GDP in following ways :

1) Yiield Spread and Equity Prices

Theoretically, a rising yield suggests that equities are undervalued. Under usual circumstances, it prompts portfolio managers to increase exposure to equities. when the earnings yield exceeded the bond yield during the Taper tantrum and demonetisation the equity indices gained.

The high-yield bond spread is the percentage difference in current yields of various classes of high-yield bonds compared against investment-grade (e.g. AAA-rated) corporate bonds, Treasury bonds, or another benchmark bond measure.

This time, however, a pandemic of Covid-19 has raised concerns of a global recession, which affected bond yields. The probability of the US recession in the next 12 months has risen to 52.8 per cent, according to Bloomberg Economics data. Therefore, portfolio managers would observe more caution while taking fresh positions in equities despite their improved attractiveness.

2) Yield Spread and Inflation

Inflation erodes the purchasing power of a bond's future cash flows. Put simply, the higher the current rate of inflation and the higher the (expected) future rates of inflation, the higher the yields will rise across the yield curve, as investors will demand this higher yield to compensate for inflation rise.

Yield curve tends to flatten when there is a tightening of monetary policy, and that a slowdown in economic activity and inflation typically follows such a policy move with a lag

3) Yield Spread and GDP

Normally slope of the yield curve, usually measured as the difference between the longest yield in the dataset and the shortest maturity yield. The higher the slope or term spread, the larger GDP growth is expected to be in the future.

Inevitably, recessions are followed by expansions. During recessions, upward sloping yield curves not only indicate bad times today, but better times tomorrow. Guided from this intuition, many research predict GDP growth in OLS regressions with the slope of the yield curve, usually measured as the difference between the longest yield in the dataset and the shortest maturity yield.1 The higher the slope or term spread, the larger GDP growth is expected to be in the future.

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