WHAT THE YIELD CURVE IS TELLING US
By: J SCOTT
There's lots of talk again these days about the yield curve and the fact that it’s seeing it’s biggest inversion in history.
Which is leading a lot of people to ask, “What is the yield curve and what does an inversion mean?”
So, let’s tackle those questions this week…
WHAT IS THE YIELD CURVE?
If you remember back to our discussion of bonds a few weeks ago, you might remember that bonds generate interest for those who buy them, and we often refer to that interest as “yield.”
The government often sells bonds to raise money, and as a way to increase the money supply. Some bonds are very short-term – they pay fixed interest for a few months and then expire and return the principal back to the purchaser. Some bonds are very long-term – they pay fixed interest for decades before expiring and returning principal. For example, when you hear “10-year treasury bond,” that’s a bond that pays for ten years before expiring and returning the principal to the purchaser.
Because these government bonds pay fixed interest (yield), when you buy bonds that expire quickly, you should generally expect to get a lower return than if you bought a similar bond with a much longer expiration date. This is because buying longer-term bonds is riskier to the purchaser – if bond rates go up over time, the purchaser is still locked into a lower interest investment, and loses out on the higher rates.
For this reason, we typically expect that the yield on shorter-term bonds is going to be lower than the yield on longer-term bonds. For example, if we were to go back two years, to December of 2020, we would see that the yield on a 2-year treasury bond was paying .13% and the yield on a 10-year treasury bond was paying .93%.
This is generally what’s expected – shorter-duration bonds paying less than longer-duration bonds. In fact, if we were to plot the bond yields for a range of different durations, we generally expect to see that curve going from the lower left to the upper right.
Here’s the full curve from December 2020:
This is what we call the "yield curve." And an up-and-to-the-right yield curve like this is a sign of a healthy economy.
YIELD CURVE INVERSIONS
But, when investors get wary about the economy -- for example, they foresee a recession coming -- they start to look for a safe place move money longer-term. They start to mover money out of shorter-term and riskier investments (like short-term bonds and the stock market) and into longer-term bonds.
All this money flowing into longer-term bonds increases demand for these bonds. And an increased demand in bonds translates to higher bond prices, which in the bond world means a reduced yield on those bonds.
And as investors start moving money out of short-term bonds (again, they want longer-term safety), this reduction in demand results in lower short-term bond prices, and higher short-term bond yields.
As investors get more and more concerned about the economy, the yield curve flattens, as short-term bond yields increase and long-term bond yields drop. When investors get really concerned about the economy, we often see short-term bond yield go higher than long-term bond yields, and instead of seeing a curve that goes up-and-to-the-right, we see a U-shaped curve or a curve that goes down-and-to-the-left.
Here is what the yield curve looks like today (December 5, 2022):
WHAT THE INVERSION MEANS
As it turns out, one of the best predictors of a recession is the yield curve. Generally, about 12-18 months before a recession, we will see the yield curve invert, with shorter-term bond yields surpassing longer-term bond yields.
In fact, a yield curve inversion has preceded the last seven recessions.
And the yield curve today is indicating the biggest inversion we've seen in nearly 40 years!
This is leading a lot of economists and investors to believe that we are likely on the cusp of a much larger recession than we've seen so far this year.