The Inverted Yield Curve: Harbinger of Doom or Yoga Position?
A “Typical” Yield Curve
A yield curve is simply a chart depicting current interest rates on bonds with varying maturities. When analysts discuss “the yield curve” they typically mean interest rates on US treasuries. Most often (for reasons we’ll discuss below), longer bonds have higher yields than shorter bonds and, thus, a “typical” yield curve looks something like the chart below, depicting treasury yields from early 2015:
Yield curves look like this most often because risk and return are related. Other things equal, longer bonds are more sensitive to unexpected changes in interest rates than shorter bonds. Here’s why: imagine you buy a one-year bond today with a 2% yield and the next day, rates rise 1%. Investors can now buy one-year bonds that pay 3%, so the price of your bond goes down to adjust to the new rates – no one is likely to pay you full price for your bond that yields less than new bonds. In this simplified example, the price of the 2% bond would likely drop about 1% (because the investor gets 1% lower interest for one year). Not ideal, but most folks wouldn’t feel too bad about a 1% drop in price.3
But what about longer bonds? If our hypothetical investor instead bought a 30-year bond the day before a jump in rates, she would be locked in to the lower yield for 30 years. As above, the price of her bond would also adjust to the new rates. It would, however, likely drop much more than 1%. Holding the 30-year bond means she gets 1% lower interest for 30 years and, therefore, we’d expect the price of her bond to drop as much as 30%. Ouch.
That’s why investors typically demand a higher yield for holding longer term bonds; they require compensation for the additional risk of rising rates, what analysts call “interest-rate risk” or “term risk.”
An Inverted Yield Curve
It’s rare, but the typical relationship between bond length and yield doesn’t always hold. In fact, it didn’t during part of last quarter. Below is a chart of the yield curve at the end of March:
We can see the shape of the curve is quite different than the “typical” curve. On March 29, one could buy a one-month treasury with a yield of just under 2.5%. A three-year treasury, however, offered only about 2.25%. Although we can see higher rates at the longest part of the curve, it’s clear that 3-to-7-year treasuries had lower yields than those maturing within one year. That is an inverted yield curve.
Why Does the Yield Curve Invert?
As noted above, risk is a major factor affecting bond yields. Longer bonds tend to have more term risk than short bonds and, thus, tend to have higher yields to compensate investors for that risk. But risk isn’t the only factor. Future expectations also affect bond yields.
Bond analysts and investors think hard about whether interest rates are likely to rise or fall in the future and make decisions accordingly. The math is complex, so we’ll simplify here. If you knew that rates were going to go up soon, you probably wouldn’t buy long bonds. Instead, you’d buy a short-term bond (or hold cash) and wait until rates went up. Conversely, if you knew rates would soon fall, you’d be more likely to act quickly to buy more and longer bonds. A yield curve, thus, incorporates the collective best guess of all bond market participants regarding future rates.
A typical yield curve means bond investors expect rates to remain roughly the same or rise in the future. An inverted yield curve means bond investors expect yields to go down in the future. It doesn’t happen very often, but that’s what it represents.
Inverted Yield Curves and Recessions
From the headlines, it appears financial media have assumed the inverted yield curve means a recession is approaching like a near-term certainty. The thinking goes something like this: (1) bond investors expect lower rates, (2) lower rates mean a recession is on the way, (3) recessions lead to lower stock returns, (4) watch out!
Although the curve does indicate market pessimism, we do not believe a recession this year is a fait accompli.
We agree that falling bond yields and recessions tend to go together, and for two reasons. First, investors often seek safety during recessions and tend to buy more bonds. More buyers mean higher prices; and, other things equal, the higher the price the lower the yield. Second, the Federal Reserve often lowers the Federal Funds Rate (the rate banks can charge each other for overnight borrowing) during recessions to boost economic activity. Doing so puts downward pressure on yields.
But there are many other reasons why investors might expect lower yields. In January, for example, Federal Reserve Chairman Powell explained the central bank will be “patient” regarding future interest rate hikes and that the Fed is sensitive to stock-market volatility.4 Recently, President Trump explicitly called for the Fed to take action to lower interest rates.5 Either comment might lead reasonable investors to expect lower interest rates without the prospect of an imminent recession.
Even assuming a recession is nigh, it’s not clear equity investors face poor returns in the near future. Here the media miss a very important fact: the yield curve didn’t invert overnight. Supply and demand impact bond yields on a daily basis. The yield curve has been changing slowly over time. This means the markets – both stock and bond – have already incorporated this information. We’d expect a market jump or swoon only if things turn out materially better or worse than current expectations.
Conclusion
Regarding the insouciant titular question: it’s neither one, but rather something in the middle. The inverted curve indicates that bond investors expect rates to go down. That may indeed mean slower economic activity and, perhaps, disappointing returns. But the yield curve represents the market’s best guess; there’s no guarantee that rates will indeed drop. Moreover, rates can go down for a variety of reasons, only one of which is a recession. Finally, the information leading bond investors to expect lower returns is already priced into the equity markets. It’s not clear what stocks will do if, as the yield curve allegedly predicts, the US economy does go into a recession.
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1 Global stocks represented by the MSCI All Country World Index. Source: Morningstar. Past performance is no guarantee of future results
2 See, e.g., Recessions and Yield-Curve Inversion: What Does it Mean?, Forbes.com, March 29, 2019.
3 Bond prices and yields have an inverse relationship: other things equal, the more you pay for a bond the lower the yield you get.
4 Powell: Fed ‘will be patient’ as it mulls more rate hikes, boosting stocks, USA Today, January 4, 2019.
5 Trump calls on Fed to cut rates by 1% and urges more quantitative easing, CNBC.com, April 30 2019.
Chief Investment Officer
