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An Inverted Yield Curve - What, Why, and ?

April 3, 2019

 

On Friday March 22 2019, an economic indicator caught investors’ attention. The yield on the 10-year treasury note fell below the yield on the 3-month treasury bill. This rattled the stock market.

 

Before getting caught in the paranoia, let us look at what a yield curve is, how it behaves, what happened that raised concerns, and what it might mean for financial markets. And last but not least, what it means for us investors.

 

What is the yield curve?

 

The yield curve is nothing but a plot of the yields on all treasuries maturing from 1-month bills to 30-year bonds.

 

Normally, the yield curve is an upward slope. An investor holding a bond with longer maturity is taking more risk and hence expects to be compensated for the added risk. So, a 30-year bond would typically yield more than a 2-year bond. And hence, under normal circumstances, the yield curve is upward sloping.

 

There are times when some parts, or all of the yield curve ceases to be upward sloping. This happens when yields on shorter-term maturities are higher than longer-term ones, and this creates an “inverted” yield curve.

 

What happened on March 22 2019?

 

On Friday, for the first time since the Great Recession, a 3-month treasury bill yielded more than a 10-year note.

 

Shorter-term rates are driven by the interest rate policies of a central banks such as the U.S. Federal Reserve. Longer-term rates on the other hand are more influenced by investors’ expectations of the future. When investors are nervous, they abandon stocks and other riskier investments for safer investments like treasuries. High demand for bonds sends the yields falling.

 

The yield curve has been flattening for some time. However, on Friday, weak Eurozone economic data created a bond rally. This pulled down the 10-year treasury note below that of the 3-month T-bill.

 

Why does it matter?

 

A yield curve inversion is considered a classic signal of future recession.

 

Interest rates affect the way banks work. Banks borrow on shorter term rates and lend on longer term rates. When their borrowing costs are higher than their lending costs, they tighten their lending operations. Under this tightening, companies find it more expensive to fund their operations and tend to limit their investments. Consumer borrowing costs also rise and impacts consumer spending. These slow economic activity, and eventually the economy contracts.

 

Is a recession coming?

 

According to the researchers at the San Francisco Fed, an inversion of the yield curve has preceded each of the past seven recessions.

 

However, a single day of an inverted yield curve doesn’t necessarily mean a recession is imminent. Campbell Harvey, a Duke University finance professor whose research first showed the predictive power of the yield curve, believes that an inversion must last an average of three months for it to be considered sending a positive signal. If this does happen, it still takes the economy nine to eighteen months to fall into a recession.

 

But even with the yield curve’s track record for predicting recessions, Professor Harvey emphasizes that there is no such thing as certainty in economic forecasting. An inverted yield curve has sent false positives when inversion of the yield curve was not followed by a recession.

 

Also, many economists believe that in the aftermath of quantitative easing measures, global central banks had snapped up government bonds. Since so many treasuries are held by central banks, the yield can no longer be seen as market-driven, which may not make inversions a reliable predictor any more.

 

What about me?

 

As investors in capital markets, we must accept that recessions, and the bear markets that are associated with them, will happen many times over the course of our lifetime. This is exactly why we incorporate how much risk we can tolerate in our investments.

 

Moments like these should not define our investment strategy. Our investment strategy should be based on our individual financial situation. We cannot control whether or not the yield curve inverts; all we can do is know and understand if we have the risk tolerance and time horizon to ride out a recession.

 

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