The stock market have been very generous towards investors during the recent years and the S&P 500 index is at its highest levels now. Unfortunately, good past returns do not guarantee good future returns and some market analysts, economists, and investors have started to worry about the yield curve movements. It seems that this topic is extremely popular among market watchers these days, so let's dive into it one more time.
In today's article, we'll explain what does it mean when the yield curve is inverted, why it's important, and what a flat and a normal curves are.
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What is the Yield Curve? Simple Definition
The yield curve is a visual representation of investments’ yields (usually bonds’ yields) across different contract lengths. The yield curve graph simply shows the investment's maturity dates (1, 2, 3, 6, etc. month or year) on the X-axis and yields (1.83%, 3%, 4.15%, etc.) on the Y-axis. When we connect the dots and draw a line across them, it'd be the yield curve.
“Yield” may seem as a confusing word, but it just means return of a bond or an income from a stock's dividend payments. Often, by the yield curve, an American article or a publication implies the U.S. dollar interest rates paid on U.S. Treasury securities as it's some sort of a benchmark, but it's not always so, it can be a corporate bond or a different debt obligation (an IOU).
A flat yield (aka current yield, interest yield, or income yield) of a 2% implies that $100 worth of market security would generate a payment (income) of $2 for its holder per year. However, the yield in the yield curve model is not a flat one, but a different and a bit more complicated yield to maturity (YTM) that takes into account the total capital gain or a loss arising on the bond between now and the redemption date.
So, the yield curve represents how yields change depending on the maturity date of a bond, and it also shows what the bond market participants think of the overall economic situation at the moment and where it may go in the future.
The Normal Yield Curve
This state of yield curve looks like a graph where short-term investments have lower yields than long-term investments. In other words, an investor will get a higher income by investing his capital for a longer period.
The normal yield curve is also known as an upward sloping yield curve and it's usually observed when the economy in a good shape and when the future looks bright.
The explanation of why this kind of curve is called “normal” is quite simple and logical: a longer period of investment implies more risks associated with it. People who lock down their money for a longer period expect to get a higher income because they might miss some short-term opportunities during this time, this is how most of the bonds and even bank deposits work.
A loan (and bonds are essentially loans) with a long duration might look attractive when there are few risks and everything seems predictable. Long-term bond prices are especially sensitive to inflation so if those prices are high, it usually means that the inflation expectations are low.
Comparing Different Yield Curves
Sometimes yield curves of different assets can be compared on the same graph to see the relation between them.
For example, you can compare a relatively stable American debt, U.S. treasury securities, with a bond of a problematic European country, say, Greece. Those two yield curves could have a similar shape and both of them might be “normal” (not inverted), but they won't be on the same level.
The Greek bond will probably have a higher yield that reflects the fact that it's riskier, there is a chance of a default of the whole country and it's higher than the chance of the U.S. bankruptcy.
So, on the graph, the Greek yield curve will be located at a higher level, and the distance between these two curves is called the spread. The spread can be either narrow or wide. This visual representation helps investors to make wise financial decisions and catch the moments when alpha (the difference in returns) of a certain bond is favorable for its purchase.
The Inverted Yield Curve
The inverted yield curve looks exactly the opposite of the “normal” one.
You can see on the illustration above that the yields for short-term investments are higher than the yields for long-term investments, which is seen as an abnormality and a warning sign of upcoming troubles in an economy.
Why the Inverted Yield Curve is Seen as a Sign of Trouble?
The situation when the yield curve is inverted, i.e. it's a downward sloping yield curve, is seen as a negative scenario by many market experts and there are strong reasons for that. Historically, almost in all the cases when the yield curve inverted, it was a definitive sign of a coming recession or other economic troubles, here is just one source (Campbell R. Harvey, 1986) that proves that.
The inversion of the yield curve preceded all of the major American recessions, including the subprime mortgage crisis of 2007.
When a normal economic cycle is expected to be at it's breaking point, the investors tend to prefer long-term bonds so the demand for those bonds rises and the yields fall: that is why the curve inverts. Why longer-term bonds? That way, lucky investors can “fix” a higher interest rate before it gets cut by the central banks in order to fight the recession, but those investors should be careful about the dangers of sudden spike in inflation which might be disastrous for long-term bond prices.
Partially Inverted Yield Curve
Occasionally, the whole yield curve wouldn't be fully inverted, but a part of it might be.
Often, a partial inversion occurs in the mid-term periods because people are not sure if the curve going to invert completely. Also, they worry about possible short-term actions of a regulator that might influence short-term yields.
This type of curve is quite common and it's what the American economy experiencing at the moment.
You can read more about a partially inverted yield curve in this article.
Flat Yield Curve
A flat yield curve is observed during transitions between normal and inverted curves. When the curve is flattening, it indicates that the yield spread between long-term and short-term bonds is decreasing, which can either be a good or a bad sign, depending on the state of the curve before that.
Such a curve motivates investors to pick shorter-term bonds as they have a similar or even a higher yield as the long-term bonds.
Is the Current Yield Curve Inverted?
At the moment, the U.S. Treasury Yield Curve is a bit weird. It's partially inverted and it's also flat for the mid-term periods, but yields for the long-term stay above those levels, which makes it overall almost normal.
Here are the current yields of the U.S. Treasury bonds according to treasury.gov as of 11/29/2019:
- 1-month yield: 1.62%
- 6-month yield: 1.63%
- 1-year yield: 1.6%
- 2-year yield: 1.61%
- 10-year yield: 1.78%
- 30-year yield: 2.21%
The short-term bonds (1 and 6 months) have slightly higher yields than 1 and 2-years bonds, but the 10-year bond overperforms the 1-month one, and the long-term 30-year bond has a far superior yield of 2.21% that covers the current inflation rate of 1.8%.
Should We Expect a Recession?
Many recent articles from almost all major financial media mention an upcoming American recession, here is just a few of them:
- Inverted Yield Curve Suggesting Recession by Forbes
- A Recession Warning by Nytimes
- Recession watch by Washingtonpost
- Countdown to recession by Reuters
A portion of such publications could have a political agenda, but the basis of those predictions is not political, they are mostly based on the fact that the yield curve is currently close to inversion and record-high levels of the stock market.
Some experts say that the model has changed and the fact that the inverted yield curve successfully predicted recessions in the past doesn't mean that this works in today's economy. So, the fact that the curve is inverted or close to this point might not always predict an economic crisis, there are more economic indicators to consider.
Also, at the moment, the American's yield curve inversion looks brief and not permanent, it's on the borderline of inversion, but it's far from being fully inverted or flat, as the difference between the lows and the highs yields is still significant.
When the curve becomes completely flat or inverted, then the recession warning might be more convincing.
Plus, the yield curve is not the only thing that may signify a recession, there are plenty of important metrics and indicators in macroeconomics that should be considered as well: the retail sales data, unemployment, inflation, production, debt, trade, business activity, etc. However, an inversion of the curve is not a positive sign for sure and this fact shouldn't be ignored.