When markets get insecure, everyone talks about the yield curve. Its inversion is often seen as a sign of an impending recession. But what exactly is it?
To understand a yield curve, you have to understand bonds. A bond is a promise made by a company or the government to an investor that the invested money will be returned to the investor with interest. The rate of interest the investor earns in the yield. It is basically the cost of money.
The yield curve depicts the rates of interest, at a given point in time, of all bonds with similar characteristics but different maturity dates. The most commonly studied yield curve is the Treasury yield curve, which plots the interest rates of the 1 month, 3 month, 6 month, 1 year, 2 year, 3 year, 5 year, 7 year, 10 year, 20 year and 30 year U.S. Treasury debt. This is where the U.S. Treasury publishes its updated data on the yield curve.
The video below shows how the shape of the yield curve has changed since 1990. The x-axis shows the maturity of the U.S. Treasury debt and the y-axis shows the yield in %. The data is obtained from the U.S. Treasury website.
Types of yield curves
A normal yield curve is upward sloping. Long-term rates are higher than short-term rates. An inverted yield curve is downward sloping. Below is an example of a normal curve and an inverted curve.
A normal yield curve shows that the economy is healthy and growing. It indicates that long-term bondholders are compensated more for the maturity risk they take than short-term debt-holders. The excess yield over short-term debt is called a maturity risk premium. There are two factors that can cause the yield curve to invert. The first one is increasing the short-term rates and the second is by reducing the long-term rates.
Factors that can change the shape of the yield curve
The Fed can influence the short-end of the curve by raising short-term interest rates. By raising short-term rates, the Fed tries to rein in inflation and short-term borrowing by making it more expensive to borrow. When the economy is sluggish, the Fed lowers short-term interest rates to encourage borrowing. Since the end of 2015, the Fed slowly started raising short-term rates.
When economy is in good shape, investors take money out of long-term bonds and invest in historically riskier assets such as stocks. The lower demand for long-term bonds causes the price of long-term bonds to go down (Basic demand curve of Economics). Since the price of a bond is inversely proportional to its yield, the yield goes up. The reverse happens when the economic outlook is bleak. When investors think that the economy is in bad shape, they pull out of the stock market, and invest in long-term bonds causing prices to rise and yields to drop at the long-end of the curve. This is what happened towards the end of 2018.
The market has had a bull run for the past 10 years and unemployment is at its lowest level. Inflation hasn’t returned yet but that hasn’t stopped the Fed from raising short-term rates. Increasing short-term interest rates and poorer investor sentiment can cause the curve to flatten and eventually invert.
The most common measure of inversion is the spread between the 10-year U.S. Treasury yield and the 2-year U.S. Treasury yield. When the spread is negative, it indicates an inversion. Historically, an inverted curve has been followed by a recession. In the chart below, the shaded areas indicate recessions.
As of February 14, 2019, the yield curve has not inverted but it is flattening. The spread between the 10- and 2-year Treasury yields are closer to zero. But this could change as Fed increases short-term interest rates and investors put more money in long-term bonds and the yield curve could invert, indicating an imminent recession.
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