Inverted Yield Curve – What’s all the fuss about?

On the 22nd of March, the US yield curve, a leading indicator closely monitored by investors, inverted. You may wonder, rightly, what this means and why the yield curve creates a fuss when it changes shape. Moreover, why the major fuss when it inverts, which is also sometimes referred to as a negative yield curve.

First, we need to briefly explain the yield curve. Basically, governments issuing bonds stagger their repayment dates. This helps smooth out the pattern of borrowing. To do this they offer bonds with a range of maturities, usually stretching out up to 30 years.

Investors buying bonds today from the US or UK governments are fairly certain they will get their money back, but, over time, they worry about a different risk- inflation. At the point of purchasing bonds, they do not know what inflation will be over the next 5, 10 or 30 years. Thus, for longer dated issues they usually demand a higher yield. This compensates them for accepting the risk posed by inflation which directly impacts the real return they expect.

By demanding additional compensation for longer dated maturities, investors should expect to see a yield curve sloping up with time. The chart below, purely hypothetical, shows what the curve should look like under these conditions i.e. lower rates at the short end, growing steadily higher over time and thus upward sloping.

Hypothetical ’Normal’ Yield Curve

Source: TPI, March 2019

Of course, the economy constantly changes and yield curves can stray from their ‘normal’ shape. At times they may be flat, steep and, as discussed, even inverted right along the curve or in parts of the curve. The deduction from yield curve flattening is that economic activity is being forecast to slow, which of course is happening in some areas of the economy now. When the yield curve inverts market commentators begin to worry about recession risk.

However, as we explain later this isn’t at all straightforward. In our view, the signal sent out by bond investors needs to be interpreted carefully.

Today, the yield curve has an odd shape. It is inverted in the middle section of the curve- see below.

When you look at the chart carefully you can see it is quite flat for the first 6 months of maturities but yields for maturities of longer than 6 months, and out to 10 years, start to trend lower. Further out, yields rise again, this time shifting higher than yields on offer at the short-end.

The dip in the middle is where the curve is ‘inverted’ i.e. negative. Bond investors calculate this by subtracting the yield at the short-end from yields with a longer period. When the difference between the two periods is negative, the curve is inverted e.g. subtracting the yield on a 1-year bond today from a 10-year bond, the spread or difference is -0.2%

Current US Treasury Yield Curve

Source: Bloomberg, March 2019

Many commentators are already concluding that the appearance of negative spreads is bad news. However, as we said earlier, it is important to interpret the results carefully, so we decided to dig a little deeper.

Below we show the yield curve now compared to the shape of the curve back in 2007. This is when the yield curve last inverted, and recession followed. For many this occurrence is what gives credence to the notion that an inverted yield curve is a reliable warning indicator.

Current US Treasury Yield Curve vs Pre-Financial Crisis Yield Curve

Source: Bloomberg, March 2019

Although there are some similarities in the shape we can point to some very important differences.

First, check out the left-hand scale v the right-hand scale. Interest rate levels in the comparative period 10 years ago are twice as high as they are today. The second aspect to note is that inversion in 2007 happened right along the curve, as far as the eye can see, out to 30 years. This suggests broad inversion may be needed to forecast a marked reversal in the market cycle, something we currently do not have.

Conclusions we have drawn:

When you read headlines warning of an inverted yield curve showing up now in parts of the US bond market we would ask you to keep in mind the following explanations:

US interest rates today remain very low. Recessions normally occur when interest rates or inflation levels spike upwards, sharply. Yes, rates have been pushed up 8 times since December 2015, but the US Federal Reserve have signalled a halt to any further rises. They have indicated they are no longer intent on raising rates this year, and inflation is falling.

The yield curve is thought to be distorted by Quantitative Easing (QE) policies. This involved governments buying huge amounts of bonds, thereby depressing yields. This unconventional aspect of monetary policy hasn’t featured in any prior economic cycles.

In the private sector, pension funds worried about sizeable pension deficits, have been de-risking their investment portfolios. This has pushed these ultra-cautious investors into buying longer dated bonds, regardless of low yields on offer; again, their actions push yields down even lower along the yield curve causing distortions.

The US has had 5 recessions in 40 years. This is a small sample to judge whether one measure, the spread between short and long dated bonds, is a cast iron way of signalling recession.