Understanding Inverted Yield Curves and What They Mean to You
In March of this year, the US bond yield curve inverted. What does that mean? We must take a step back and understand what and how bond yields or interest rates are determined. The term structure sets forth the relationship between bond yields (interest rates) and different terms or maturities. When this is formally plotted out into a graph, we have what is known as the yield curve. This in turn plays a key role in market participants’ expectations of future changes in interest rates. Generally, yields or interest rates increase with longer maturities. This is what economists call a normal yield curve. In commodities the term is contango, where spot or current prices are lower than future prices. As was mentioned above, the US Treasury yield curve is currently inverted. That means that short term rates are higher than long-term rates. Again, in commodities this is known as backwardation, which is the opposite condition to that when prices are in contango. Please see the figure below as of 12 June 2019.
As evidenced in the chart above, 1-month rates are higher than all those longer-term rates until you get to 20-year US government bonds.
What is the day-to-day impact for individuals and businesses? First, as the yield curve started to flatten earlier this year, and inverted for a short time in 2018, the Federal Reserve became much more dovish on hiking interest rates at the pace they initially set out in the 4th quarter of 2018. When the curve inverted, this has historically been a precursor to an impending recession. To test this hypothesis, a search of the US Treasury website shows that in the last 50 years, an inverted yield curve, one in which the majority of longer-term yields have been lower than shorter-term yields, has turned into a recession between 6 and 24 months following the inversion. From and economics standpoint, a recession means two consecutive quarters of negative Gross Domestic Product (GDP) growth. There are also times where just some of the longer-term rates are lower than the shorter-term ones. These periods have not been accurate predictors of an impending recession.
For businesses, they could find it more difficult to expand their operations due to higher borrowing costs on short-term loans. This is also true for consumers. Furthermore, consider households that have adjustable rate mortgages or ARMs. This means that in each anniversary of their loan, rates will jump. This situation applies to any debt instrument, including bonds. As an economy enters a recession, there will be a behavioral tendency for investors to seek shelter in safer investments. That means investors will move toward bonds, which will in turn increase bond prices and lower their yields. Unemployment will rise as businesses borrow less and the downward spiral of the economy will continue until some floor is met. As investors, it’s important to understand that these are temporary and expected occurrences in any economy. Investors need to be vigilant in maintaining their diversified portfolios and to continue to rebalance should equities decline in value.
Risk Warnings and Important Information
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