The Inverted Yield Curve is an important concept in economics. Although a rare phenomenon, an inverted yield curve raises worries and concerns on what it means for the future of the economy, as it is seen as a prediction of an impending recession. Knowing about the yield curve and being capable of reading into the trends indicated by the curve will help investors brace themselves against losses by allowing them to strategize their financial plans accordingly, and by preventing them from falling prey to bad advice or bad investment decisions.
In this article, we will break down yield curves and how it impacts your investments.
What is an Inverted Yield Curve? The Basics
To understand what an Inverted Yield Curve is, we first need to understand what a Yield Curve is. A Yield Curve is a line on a graph that plots the interest rates (called yields) of government bonds that have similar credit quality but varying maturity periods. A lower yielding bond typically has lower maturity, and larger yields generally have longer maturity periods. A bond is an investment that returns your original invested amount along with a rate of interest calculated over a certain period. The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year and 30-year US Treasury debt (Government Bonds).
The slope of the yield curve gives an idea of future interest rate changes and economic activity and is indicative of the investors’ sentiments about the economy. Let us look at how bond interest rates correlate with market sentiment.
When the Fed fixes a high interest rate for the bonds (i.e., a high yield), investors tend to flock to this investment, as they find it lucrative. This, in turn, pushes down the market price of the bonds. This means, while you do get the promised amount as interest on your investment (called coupons), the price of the bond in the open market goes down (as a result of demand and supply). As investors start to dump their bonds, it pushes prices of the bonds even lower and the yields even higher. It is necessary here to note that a higher yield indicates greater risk. If the yield offered by a bond is much higher than what it was when issued, there is a chance that the company or government that issued it is financially stressed and may not be able to repay the capital. Of course, government bonds are relatively more stable, but low demand at auctions indicate low investor confidence in the country’s economy.
Conversely, if the bond’s yield is low, there will be very few investors willing to purchase it, and hence, the bond price is higher in the open market. This indicates a greater confidence in the public that you will get your investment back, and that the government has money to fund projects for national development. The yield curve is considered important as it stands as a benchmark for other kinds of debt in the market, such as mortgage rates or bank lending rates.
Understanding Different Yield Curves
There are essentially three curve patterns that can be formed on the graph when you plot the yields of different bonds:
1. Normal Yield Curve: A normal yield curve shows that the investors are confident. They are not quite interested in long-term notes, causing those yields to rise steeply. When there’s a normal yield curve, you’ll be paying a much higher rate of interest on a 30-year fixed mortgage compared to a 15-year mortgage.
2. Flat Yield Curve: A flat yield curve shows that the yields are low across the spectrum. It shows that investors speculate slow growth. A flat yield curve could mean that economic indicators are not very clear, and some investors expect growth while others are unsure of the returns. A flat yield curve means that an investor is not going to save much on a 15-year mortgage. Instead, one might invest in a 30-year fixed mortgage and reap the benefits longer.
3. Inverted Yield Curve: An inverted yield curve speculates a recession. This is when the yields on bonds with a shorter investment period are higher than the bond yields that have a longer investment period. In this scenario, investors are not confident in the near-term economy. They demand more yield for a short-term investment. In simpler words, an Inverted Yield Curve shows that younger Treasury Bond yields are returning more interest than older ones.
What Does an Inverted Yield Curve Represent?
An inverted yield curve on Treasuries is most concerning. That is, when yields on short-term Treasury bills, notes, and bonds are higher than the longer duration yields. The US Treasury Department sells these securities in 12 maturities. These are:
- Treasury bills issued with maturity periods of 4, 8, 13, 26, and 52 weeks
- Treasury notes that mature in 2, 3, 5, 7, or 10 years
- Treasury bonds that mature in 20 and 30 years
An inverted yield curve indicates that investors believe they will make more money buying a short-term Treasury Bill than by buying a long-term Treasury Bond. That is, the faith in the government’s capacity to pay back money in the long term is affected. If they speculate a recession is coming, investors expect the value of the short-term bills to dip very soon, and hence, they are compelled to pull out money faster. They are aware that with a short duration bond, they have to reinvest that money in a few months. The investors are also aware that the Federal Reserve lowers the fed funds rate when the economy slows.
What Causes an Inverted Yield Curve?
Why does the yield curve become inverted? In an ideal scenario, the long-term bonds are supposed to have higher yields (therefore a lower market price). Motivated by the fear of losing one’s investment in the near-term, because investors suspect the economy is heading into a recession and that the government won’t be able to pay back in the near term, investors rush to buy long-term Treasury bonds. The Federal Reserve responds to this big surge by lowering the yields on these bonds.
As longer-term bonds are more attractive, the demand for short-term Treasury bills reduces. The government then is forced to provide a higher yield on short-term bills to attract investors back.
If investors believe that a recession is coming, they will want a haven for their investments. The general market behavior is then to avoid any Treasuries with maturities less than two years. This drives the demand for those bills down, driving their yields up, hence inverting the curve.
The fear of loss makes investors anxious, which in turn makes them demand longer duration bills. This speculative economic situation causes the yield curve to invert.
The History of Inverted Yield Curves
The yield curve has inverted several times before. We will evaluate the 2008 recession to understand the sentiments and some of the causes in a market that lead to this symptom of the looming recession called the Inverted Yield Curve.
To correlate the Inverted Yield Curve with a recession, it is necessary to keep in mind that the Inverted Yield Curve is not a cause of the recession, rather it is only a symptom. This means that an Inverted Yield Curve is a prediction that a recession may be on its way. This has been observed before, with the recessions of 1970, 1973, 1980, 1991, and 2001, when the yield curve inverted.
Yield inversion predicting the 2008 Financial Crisis
A yield curve inversion way back in 2006 had indicated the possibility of a recession, which struck as the financial crisis in 2008. The first inversion happened on 22 December 2005. The Fed, concerned about an asset bubble in the housing market, had raised the interest rate since mid 2004. The interest rate offered was 4.25% on 13 December 2005.
The yield on the two-year Treasury Bill pushed toward 4.41% by 30 December. The 10-year Treasury Note was finding more takers despite sitting a little behind on yield at 4.39%. This indicated that the investors were willing to accept a lower return for loaning their money for ten years than for two years.
The difference between the two-year note and the ten-year note is termed the Treasury yield spread. It was -0.02 points. This was the first inversion towards a financial crisis.
On 31 January 2006, the Fed raised the interest rate again, this time to curb liquidity to support the currency and prices in the market. When there is more liquidity, prices of goods and services fall drastically, thereby impacting economic growth and foreign exchange. The Fed’s role is to maintain a balance.
Hence, since the Fed raised interest rates, the two-year bill yield went up to 4.54%. But this rate was more than the 10-year yield which stood at 4.53%. Nevertheless, the Fed kept raising the interest rates.
On 17 July 2006, the inversion worsened when the 10-year note yielded 5.07%, less than the two-year note of 5.12% (notice how the Treasury Yield Spread has widened further) – indicative of the fact that the investors thought the Fed was not right in its approach. This happened in the backdrop of the impending subprime mortgage crisis.
Unfortunately, the Fed did not pay any heed to the warning. The Fed had the impression that as long as long-term yields were low, they would provide enough liquidity in the economy to prevent a recession. In retrospect, we know the Fed was wrong.
The yield curve stayed inverted until June 2007. All through summer, it flipped between an inverted and flat yield curve. By September 2007, the Fed was finally concerned and ready to take action. It lowered the fed funds rate to 4.75%. It was a half point, which they believed was a significant enough drop. With this, the Fed sought to send a strong signal to the market.
The Fed had to lower the rate seven times until it was zero by the end of 2008. The yield curve was no longer inverted, but it was too late. The economy had entered the worst recession since the Great Depression.
The Impact of an Inverted Yield Curve
Although Inverted Yield Curves have been a rare economic phenomenon, their impact can be quite widespread due to a large section of the population investing in Treasury bills and bonds.
The good news is that Inverted Yield Curves do not last forever. Seeing the consequences an Inverted Yield Curve has on the economy may impact your decisions and investments. You can’t control what happens in the economy, but you can take charge of your finances. Do not make rushed, erratic decisions, and always put away emergency money, creating a safety-net.
Impact on Consumers: Inaddition to its impact on investors, an Inverted Yield Curve also has an impact on consumers. For example, potential homebuyers financing their properties with adjustable-rate mortgages (ARMs) have interest-rate schedules that are periodically updated based on short-term interest rates. When short-term rates are higher than long-term rates, payments on ARMs tend to rise. When this happens, fixed-rate loans may be more attractive than adjustable-rate loans.
Impact on Fixed-Income Investors: A yield curve inversion has the greatest impact on fixed-income investors. In normal circumstances, long-term investments have higher yields because investors are risking their money for a longer duration, and hence, they are rewarded with higher payouts. An inverted curve gets rid of the risk premium for long-term investments, pushing investors to get better returns with short-term investments, thereby negatively affecting the long-term investors in fixed income instruments.
Impact on Equity Investors: An inverted Yield Curve, in this case, would result in lower profit margins for companies that borrow cash at short-term rates. Similarly, hedge funds have to take on an increased risk to achieve the desired result.
To sum it up
Whether or not an Inverted Curve Yield is an indicator of an economic recession remains a subject of debate, but its impact on investors cannot be denied. You should keep in mind that several portfolios were negatively affected when investors followed predictions that claimed it was “different this time”, without questioning the prediction.
If you want to be a smart investor, ignore the noise. Rather than spending time and effort trying to figure out what the future will bring, construct your portfolio based on long-term thinking and long-term convictions – not short-term market fluctuations.
That said, don’t ignore the inverted yield curve! If you have investments, or plan to make investments, especially in bonds, you may want to give the yield spread a look to figure out how your returns are likely to pan out.