Understanding spreads (from 2010 AM, Q4)

CFA Level III
#1

In the question they show that the 10-year treasury bond less federal funds rate spread has increased. The answer explanation states the widening of the interest rate spread indicates that the yield curve has steepened and that a flattening yield curve would be indicative of a weakening economy. Why is this?

We know that in an improving economy, corporate bonds outperform, because their spreads narrow (tested in question 6, 2011 Exam). Therefore, in a poor economy, corporate spreads increase.

So why do increased corporate spreads over Treasuries indicate a weakening economy but increased t-bond less fed funds spread indicate a strengthing economy?

#2

very good question. I would also like to know the answer.

#3

I believe this relates to the Leading/Lagging/Cyclical Indicator stuff which has been removed as an LOS. The Economics Reading has also changed since 2010.

#4

that is just the 10yr treasury over fed fund rate, so indicates steepness of yield curve and improving outlook for economy rather than corporate spreads… it is a maturity spread rather than corporate bond spread.

#5

if interest rate curve (yield curve) is upward sloping, economy strengthens.

When yield curve inverts, economy weakens.

if credit spread curve widens, economy is weakening.

if credit spread curve narrows, economy is strengthening.

#6

ahh ok that makes me feel better. so in general would u agree that:

  1. when any non-risk free spread over treasury increases, this means that that sector will underperform (because its price will go down)

  2. when spreads over treasuries increase, this means that the economy is deteoriating

#7

+1

#8

agree