The Inverted Yield Curve

The Inverted Yield Curve

You may have recently seen the “inverted yield curve” making the news in the last few weeks, and wondered why it had such a negative impact on the stock market. The long and short of it is that an inverted yield curve is a harbinger of economic downturn. Today I will be discussing what an inverted yield curve is and why it’s an early indicator of an economic dip.

What is it?

First, I will address what the yield curve is, and why it’s bad when it inverts. Typically speaking, interest rates are higher for long-term investment opportunities than short-term ones. [1] Thus, their yields are usually higher.  Intuitively, this should make sense, as longer terms involve higher risk, and higher interest rates are seen as a way for investors to offset and accept that risk.

The yield curve is a graphical depiction of the yield’s relationship to an instrument’s term. Normally, it should depict the yield’s upward movement as the maturity date moves further away. Below you will see a crude example of a normal yield curve:

Investopedia

As the name suggests, an inverted yield curve is a graphical depiction of the yield shrinking as the maturity moves further away. This occurs when the interest rate is lower for long-term investment instruments than long-term ones. [2]  Short-term yields are normally seen as less risky, which results in them having lower interest rates and thus lower yields. [3] Here is a simplified rendition of an inverted yield curve:

Investopedia

Why is that so bad?

So, you may be thinking, “if short-term instruments are enjoying higher yields, I’ll just invest in those instead and get my money sooner. Win-win! What’s the big deal?”

Well, when the yield curve inverts, it means that banks are less confident in short-term investments than long-term ones. In other words, they’re expecting economic instability. And this has proven over the decades to be a reliable forecast for the US economy. In fact, this has proven to be true seven times in recent decades, with inversions occurring in 1968, 1973, 1978, 1980, 1989, 2000, and 2006. In all seven instances, a recession followed within 6-18 months. [4] It has proven so accurate that Federal Reserve banks have developed indices and recession probability charts either partially or entirely derived from the relationship of long-term and short-term yields, typically for treasury bonds. [5][6][7]

Why is it in the news?

The obvious answer is that the yield curve inverted [2], however, this isn’t the first time it has inverted in the last 12 months. In fact, we experienced an inversion during December of last year. [9] The inversions from 1978 and 1980 were also relatively close together and resulted in economic downturn in the early 1980s. [4] Given the economy’s performances over the last few years, media outlets that cover the economy have been talking about market corrections [9][10][11][12] – after all, what goes up must come down. Naturally, discussing a prominent warning sign, such as the inverted yield curve, is a natural continuation of that coverage.

So what happened?

So, an inverted yield curve can happen with a number of different instruments, including CDs and bonds. However, the curve that is watched to forecast the US economy is that of bonds and CDs from the US Treasury. [2][4][5][6][7] On August 14^th of this year, the interest rate on a 10-year US Treasury CD hit 1.6% while the 2-year CD was fetching 1.603%. The 3-month’s rate was 1.997% while the 5-year’s rate was 1.527%. Likewise, long-term rates have been dropping at consumer-facing banks. [14] The 10-year vs. 2-year curve for this event can be seen below:

CNBC

What now?

In accordance with past trends, it’s reasonable to expect that we are due for a market correction in line with what we’ve seen with past inversions of the yield curve. Now is an ideal time to consider alternative forms of investment such as notes that can weather the storm.

Sources:

1. Pylypczack, Daniela. “Yield Curve 101: The Ultimate Guide for ETF Investors.”Yahoo! Finance, Yahoo!, 28 Apr. 2014, finance.yahoo.com/news/yield-curve-101-ultimate-guide-110026560.html.
2. Lewis, Al. “The Inverted Yield Curve Explained and What It Means for Your Money.”CNBC, CNBC, 14 Aug. 2019, http://www.cnbc.com/2019/08/14/the-inverted-yield-curve-explained-and-what-it-means-for-your-money.html.
3. Gallant, Chris. “Interest Rate Risk Between Long-Term and Short-Term Bonds.”Investopedia, Investopedia, 8 May 2019, http://www.investopedia.com/ask/answers/05/ltbondrisk.asp.
4. Harvey, Campbell. “Yield Curve Inversions and Future Economic Growth.”Duke, 1 May 2008, faculty.fuqua.duke.edu/~charvey/Term_structure/Harvey.pdf.
5. https://www.newyorkfed.org/research/capital_markets/ycfaq.html
6. https://fred.stlouisfed.org/series/STLFS
7. https://www.stlouisfed.org/news-releases/st-louis-fed-financial-stress-index/stlfsi-key
8. Chappatta, Brian. “The U.S. Yield Curve Just Inverted. That’s Huge.”com, Bloomberg, 3 Dec. 2018, http://www.bloomberg.com/opinion/articles/2018-12-03/u-s-yield-curve-just-inverted-that-s-huge.
9. Kollmeyer, Barbara, and MarketWatch. “Expect a 10% Market Correction Within 3 Months, Morgan Stanley CIO Says.”Barron’s, Barrons, 20 July 2019, http://www.barrons.com/articles/expect-a-10-market-correction-within-3-months-morgan-stanley-cio-says-51563620700.
10. Johnson, Craig. “Johnson: Meaningful Market Correction Could Be Coming.”CNBC, CNBC, 23 July 2019, http://www.cnbc.com/video/2019/07/23/johnson-meaningful-market-correction-could-be-coming.html.
11. Williams, Sean. “The 3 Things You Must Know about Stock Market Corrections.”USA Today, Gannett Satellite Information Network, 9 June 2019, http://www.usatoday.com/story/money/2019/06/08/stock-market-corrections-here-3-must-know-things/1374287001/.
12. Otani, Akane. “Nasdaq Slides Into Correction Territory.”The Wall Street Journal, Dow Jones & Company, 3 June 2019, http://www.wsj.com/articles/stocks-bond-yields-start-the-week-with-fresh-declines-11559548438.
13. Gallo, Carmine. “How The Finance Prof Who Discovered The ‘Inverted Yield Curve’ Explains It To Grandma.”Forbes, Forbes Magazine, 18 Aug. 2019, http://www.forbes.com/sites/carminegallo/2019/08/18/how-the-finance-prof-who-discovered-the-inverted-yield-curve-explains-it-to-grandma/#11ceaf476cae.
14. Herron, Janna. “Will Mortgage Rates Keep Dropping? Homeowners and Buyers Benefit from Lower Interest Rates.”USA Today, Gannett Satellite Information Network, 11 Aug. 2019, http://www.usatoday.com/story/money/2019/08/08/homes-sale-mortgage-rates-drop-helping-homeowners-and-buyers/1954136001/.