What do you think about the inverted yield curve?
Pretty scary huh?
I get it – a harbinger of doom and recession is drawing close.
I recently wrote about hunkering down (I’m 100% Stocks and Happy with my Diversification) but an inverted yield curve – yikes! That seems serious, right?
The chart below from Fidelity shows how the yield curve has inverted before all the recent recessions (note a couple of false alarms in 1966 and 1998).
Inverted Yield Curve
And this neatly encapsulates my recent frustration. There has been an explosion of interest in the media on yield curve inversion as seen below by the Google Trends chart, but mostly the only commentary I see falls into two buckets.
The first bucket of commentary talks about the ‘where’ and ‘when’ of yield curve inversion, but not the ‘why’. They describe how a yield curve inversion has presaged most/all of the recent recessions.
But this is information and not insight.
The second bucket of commentary is far too shallow or it’s even incorrect. See for example this car crash from a high-profile blogger.
As more and more people begin to buy long-term bonds, however, the Federal Reserve responds by lowering the yield rates for those securities. And since people aren’t buying a lot of short-term U.S. Treasury bonds, the Fed will make those yields higher to attract investors.
Firstly the Federal Reserve (Fed) doesn’t control the yields on long-term bonds. Long rates are simply a function of the demand and supply and resulting price of long-term bonds, the Fed has no direct control over that. Secondly the Fed has a dual mandate to control inflation and keep unemployment low; It’s completely irrelevant that there might be an imbalance of investors of long-term and short-term bonds. The Fed could not care less about that. They use monetary policy (raising and lowering the Fed funds rate) to try and directly influence the economy and ultimately increase the chances of succeeding with their dual mandate. They do not try and control the shape of the yield curve.
What are Interest Rates?
If the Government needs to borrow money to build a road, or pay teachers, or put gas in Air Force One, then they might borrow money for a year to makes ends meet or to manage cashflow.
Suppose you lend $100 to the US Government for a year, how much do you want to be paid?
You can’t demand too much reward since it’s a pretty safe investment. You’re gonna get paid back. The US Government won’t go bust, they’ll simply print more money, or raise taxes to pay you back. So it’s pretty certain you you’ll have your $100 returned in a year.
But you don’t just want $100 returned to you after a year, you want to at least get compensated for one year of inflation since in one year your $100 won’t be worth as much. Or said a different way, in one year’s time your $100 will buy fewer goods. If you thought inflation was 2% then you would want to be repaid at least $102.
But you don’t just want to get your money back plus inflation, right?
You want a bit of a premium on top, don’t you?
Maybe $1 is a fair premium to ask for.
So in total you might ask the Government for $103 to be returned at the end of the year in return for lending $100 now. That way you’re getting compensated for your future expectation of inflation plus a little bit on top in exchange for tying up your funds for a year.
In my example above the $3 is called the ‘nominal’ interest rate, and that is made up of $2 of inflation expectation and $1 of ‘real’ interest.
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What is the Yield Curve?
Interest rates vary with the length of time you lend for.
If you want a mortgage for 30 years, then you will be charged a higher interest rate than if you want a mortgage for 15 years.
In the same way if you lend to the Government for 30 years then you would naturally ask for a higher interest rate than if you lent for a 1 year period. After all, you are locking up your money for 30 years. If you suddenly needed that money in the intervening period to buy a car, or invest in your brother’s business, or pay college fees, then tough! You’ve lent it to Uncle Sam for 30 years.
You also have a lot more uncertainty about price inflation over 30 years. I might be reasonably certain that inflation will be around 2% over one year, but what’s it going to be over 30 years? Search me! If I’m going to lend for 30 years, then I’m gonna need some compensation in the form of higher rates.
Yield Curve Slope
So you can see that we’ve made the case for an upward sloping yield curve. We expect to be paid higher interest for lending to the Government for longer periods. If we want to be paid for inflation uncertainty and be rewarded for locking-up our money then we expect 30 year rates to the be the highest, 10 year rates the next highest, and 1 year rates the lowest.
Makes sense?
Right?
It makes perfect sense.
An upward sloping yield curve should give you the same warm comforting glow that you get from a bite of homemade mac-and-cheese fresh from the oven. That familiar, mood-enhancing shot of cheesiness from Mom’s recipe. It signals that all is right with the world.
Which is why an inverted yield curve scares the bejeezus out of everyone!
It signals red!
It flashes!
There are sirens!
It’s like your worst, curdled, cold, sour mac-and-cheese.
But what’s so bad about an inverted yield curve?
Inverted Yield Curve
We should feel uneasy about an inverted yield curve. Perhaps we should feel afraid. But honestly, I’ve never really felt that I knew enough about it. I know it doesn’t make sense, but I was never really able to articulate why.
And ignorance causes fear.
Am I right?
If you don’t get it, then how do you know whether to fear it?
Is that long grass simply rustling in the wind, or is there a tiger hiding ready to pounce?
Let’s look at an example and compare two recent yield curves, one at June 24, 2019 and August 27, 2019.
You can see that rates came down a lot – around 0.5% (50bps) – over that period. But long rates came down more than short rates. I’ve highlighted the 2 year and 10 year rates and you can see that over this period the yield curve inverted (gasp!).
But Why?!
Why on earth would an investor accept a lower interest rate for a ten year term over a 2 year term?
One way to think about this is that if you are buying Treasury bonds for ten years, then you can either buy a ten year bond and be certain of your return (in nominal terms) or you could buy a series of two year bonds. When your two year bond matures you simply buy another one.
You might accept a lower return for a ten year bond if you feel that you would actually be getting a better deal than rolling over five consecutive two year bonds. If you think short term rates might fall, then two year bonds in the future might yield a lot less than current, in which case that ten year rate might look pretty juicy.
Short term rates are highly correlated with the Fed’s monetary policy. If the Fed reduces the Fed funds rate then short term bond yields generally fall. So the situation I describe above is consistent with investors expecting future aggressive reductions in rates by the Fed (‘easing’). And aggressive rate reductions are associated with wanting to simulate the economy by making it cheaper for people and companies to borrow money, and hopefully then spend it.
If you are expecting a downturn in the economy in the future then you would expect that to be accompanied by Fed easing of monetary policy and so you might prefer to lock in a lower long-term rate now, even though it’s lower than the current short-term rate.
Half the Story
However what we’ve discussed above is only really half the story.
Remember we said your reward for lending to the US Government is composed of two parts; one part to cover inflation over the period and other part (‘real rate’) as a bonus? We can decompose our yield curve into two parts – the market’s view of future inflation and the resulting real rates.
Let’s do it!
The chart above shows Treasury bond investor’s future views of inflation at the two dates we examined above.
You can see on June 24th investors were expecting future inflation to be around 1.8%. This changed quite dramatically on August 24th where inflation assumptions came down around 0.2% (20bps). This might not sound much, but it’s not a vote of confidence in the future path of the economy, or a vote of confidence in the Fed being able to manage towards its target of 2% inflation.
This view is consistent with a weak economy. If there is little demand for goods then there will be less pressure on prices and so future inflation could be lower.
Let’s look at real rates.
Real Rates
In the chart above I have shown the yield curves (‘nominal’ curves) along with the real rates from 5 years onwards.
You can see that there was a big drop in real rates of around 0.4% (40bps). This is a big change in the expectations of the ‘bonus’ that bond investors are willing to take for investing in Treasuries. They are saying:
“Hey! in June I was happy with a bonus of about 0.3% from lending to the Government for ten years, now in August I would honestly be pretty happy just to get my money back and cover inflation!”.
Over this period more and more investors bought bonds to protect themselves against a perceived weakness in the economy and a fear that stocks might suffer a fall. All this demand for bonds drove down the yield on long bonds to a point where investors had to swallow a slightly negative real yield on ten year bonds.
Investors are going to the dance but have no choices, and Treasuries yielding negative real returns are the best date in town. So they’re holding their nose and taking it!
Not the Tail that Wags the Dog
In the case of the two dates I’ve chosen it’s a pretty ugly picture.
Both real rates, and inflation expectations have come down fairly dramatically to the point that real rates are close to zero or even below zero. Bond investors are voting with the buy-button and signaling that other assets are too risky, the Fed will drop rates aggressively, and future inflation could fall. These are all unpleasant signals on the future path of the economy.
However it’s worth saying that the yield curve is not the tail that wags the dog.
The shape of the yield curve does not cause economic turbulence.
It simply reflects the views of current bond investors who may, or may not, be correct.
I’ve found that simply understanding these signals can help de-mystify the flashing red lights and klaxon horns from the financial media and reduced my anxiety about these issues.
Ignorance.
Understanding stuff and appreciating the underlying drivers can help you take these events in your stride and adjust course if you feel you need to.
Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my regular day job I advise corporate US on investment and retirement strategies. I’m a qualified actuary, investment adviser and have a PhD in mathematics and reserve the right to have the occasional math post.
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Man, that blogger comment is just scarily wrong.
I’m not particularly fretted by the inversion, especially given some of the unprecedented events at play. If we think of quantitative easing and other recent fed tactics we realize they have been impacting the yield curve indirectly. As such the feds bond buying may artificially be impacting this read on bond holder sentiment.
The inflation meanwhile is being again discussed as on the decline. A few short months ago it was discussed as rising. That’s a measure again of sentiment this month. That doesn’t necessarily mean that is what will happen next. Since In the absence of qe2 the expectation of inflation is really what drives the yield curve I tend to conclude who knows what will happen next.
I’ve just thought that perhaps the blogger was describing the Fed’s “Operation Twist” where they were actually selling short term securities to buy longer term securities. So perhaps I’ll be charitable and say the description just got a little mangled…
I worry about the yield curve because it signals a change. The present market is all about going farther out on the yield curve, past bonds into stocks, or past treasuries and into corporate bonds, junk levered loans at ever increasing rates of debt. This is called “risk on”. A yield curve inversion indicates a change in the flow of risk purchase from “risk on”, to “risk off”. A movement from corporate debt to treasury debt, so the inverted yield curve is a market phenomenon of price discovery as investors reduce their debt apatite. It’s supply and demand. If you no longer believe BBB paper is immune from becoming junk you move down to 30 year treasuries and the demand for 30 year bonds forces down the interest of that bond. The inversion happens because of an inflection where the sign of the second derivative changes and that is the signal. It signals a change in investor sentiment, from risk on to risk off. The short end of the curve is the anchor in the calculation. If the derivative is delta interest/delta time, delta is defined at some level as i2 – i1 and t2 – t1 where i is interest and t is time.
Since the bond market is vast, picking up this signal is significant. It means in the aggregate a lot of risk off is occurring, and to get that aggregate it means institutional investors are in play. I recently took off some risk, nobody noticed. State of IL pension fund takes off risk, people notice. The guesses are Bayesian. Each subsequent guess is informed by what went before. In the first half of 2019 more businesses failed than did in the entirety of 2018. Business failure = rising unemployment. It’s likely worse since a lot of those businesses likely employed Gig workers who are not eligible for unemployment, and though jobless are not counted. I’ve seen estimates as high as 20% of joblessness goes under reported because of this mechanism. If I can figure this out you better be sure the smart money has figured this out, and like me took some risk off. I read an article today that the family offices in Palm Beach are now holding more cash than ever before. Holding cash is risk off. I’m actually holding more cash than ever before, and I’ve increased my allocation of gold. In a world of negative interest at least gold pays zero, and tends to keep up with inflation if not exceed.
The inverted yield curve is a signal and it does not exist in a vacuum. It signals the risk averse nature of human behavior by people who get paid a lot to understand risk.
I agree it’s a signal of risk aversion. My point was that it’s not really well explained *why* this actually happens. And I wanted to unpick that a bit.