You are about to start hearing a lot about yield curves in the near future. And while there is absolutely nothing you or I can do to influence the yield curve, I thought it would useful and helpful to understand them and their importance.
So, before we talk about the reasons for and consequences of inverted yield curves, let’s look at a typical yield curve and why it’s shape matters.
So……….what the heck is a yield curve and why should I care? The yield curve that you will start hearing about tracks the interest rate on the US Treasury Debt (bonds) relative to their maturity (the time in which the interest is to be repaid). The most typical and common yield curve plots interest rates on the three-month, two-year, five-year and 30-year Treasuries. In addition to being used as a benchmark for interest rates, such as mortgage rates and bank lending rates, the yield curve is an extremely important economic metric. The direction or shape of the curve is a solid indicator of both the current and future direction of the economy. And unlike other economic indicators, the yield curve is not produced by a single entity or government. Instead, it is set by measuring the feel of the market at the time.
Normal Yield Curves
A normal or upsloping yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. Below is a graph of a normal, upward sloping yield curve.
From the graph above, it is easy to see that the longer the maturity of the bonds, the higher the interest rate. And in a normal economic environment, that makes sense; the longer maturity brings with it more risk and thus a higher interest rate. The market and the bond holders usually expect higher interest for greater risk. “Longer-term bonds are exposed to more risk such as changes in interest rates and an increased exposure to potential defaults. Also, investing money for a long period of time means an investor is unable to use the money in other ways, so the investor is compensated for this through the time value of money component of the yield”.
A normal, upsloping yield curve is how the curve looks when an economy is growing and investors are confident (as we will see later, that is not what today’s yield curve is telling us). In a growing economy, investors demand an additional premium (yield) for longer maturity bonds. This is logical considering there is more risk associated with having money tied up for longer periods of time. Healthy economies nearly always have an upward sloping yield curve, although the interest rates that make up that curve may differ substantially from one period to another.
Inverted Yield Curves
An inverted yield curve is theoretically the exact opposite of a normal yield curve. And, thus its consequences are also exactly opposite of a normal yield curve. I have been fascinated by inverted yield curves for the past 25 years or so. Inverted yield curves remind me of the first time I saw a magician make a coin disappear, or the first time I saw an airplane fly; even though I see data creating the inversion, I still cannot believe what I’m seeing. While inverted yield curves may go against all common financial logic, they do occur and their consequences are predictable and bad.
Below is a graph of an inverted yield curve. As you can see, it is indeed exactly opposite of a normal yield curve. When the curve inverts, investors are willing and/or forced to pay higher rates for shorter maturities.
Yield Curve Today
So, why are you going to start hearing a lot about yield curves? Because today’s yield curve is basically flat and trending towards being inverted. The graph below is the yield curve (both nominal and real) for 7/19/2018. Quickly, the difference between the “nominal” and “real” yield is that the real yield curve takes into account the impact of inflation, whereas the nominal yield curve is simply the rate quoted with no adjustment for inflation. Investors always look for the real yield curve as that is what they actually expect to receive.
From this graph it is pretty easy to see just how little difference there is between the 5-year rate and the 30-year rate. In fact, there is only an 18 basis point difference between the 5-year and the 30-year. That means that even though your money will be tied up for 25-years longer, you only get less than ¼ of 1 percent more return. Let’s compare this to one year ago today. The graph below is the same yield curve for 7/19/2017.
The first thing you notice about this yield curve is the classic normal shape. In fact, the difference between the 5-year and the 30-year is 78 basis points, or more than four times greater than today. If we go back two years from today, the yield curve is even more “normal” and the difference in the 5-year and the 30-year is 114 basis points; more than six times greater than today. In fact, you’ll notice the 5-year “real” yield is negative when adjusted for inflation.
Ok, but what does this mean? To answer that, let’s go back and look at the yield curve months before the “Great Recession” of 2007. The chart below is the yield curve on 7/19/2007, just months before the greatest economic collapse since the Great Depression. Note that the spread between the 5-year and 30-year treasury is zero. Both the 5-year and 30-year yield was 2.63%. Compare that to today’s spread of just 18 basis points and you start to understand the significance of the yield curve.
We are very close to the point where the yield curve has to invert. Investors would be crazy to buy 30-year treasuries when you get basically the exact same return for a 5-year treasury. Thus the rate for the 5-year will continue to increase; causing the rate for the 3-year to increase; causing the rate for the 2-year to increase…….until the yield curve flattens.
In the next part of “When Yield Curves Invert,” I’ll look back at previous recessions relative to the yield curve and why the next recession will be far, far worse than the Great Recession of 2007.