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What exactly is the yield curve?
The yield curve is basically a graph showing the term structure of interest rates by plotting the yields of all bonds of the same credit quality with maturities ranging from the shortest available to the longest available. Currently for United States Treasury securities (Treasuries), the range is from three months to thirty years.
What is a yield curve inversion?
Normally, and under normal economic conditions, one would expect the yields on shorter-term bonds to be lower than the yields on longer-term bonds. If you consider it from an investment perspective, the more time you loan money to someone the more risk there is that something could go wrong with that borrower. Therefore, you would typically expect to be paid a higher interest rate the more time you lend money out. The scenario described above is known as a normal or positive yield curve where the rates on shorter-term paper are lower than the rates on longer-term paper. An inversion occurs if this flips and the shorter-term paper is paying higher rates of interest than longer-term paper.
Can this actually happen in real life?
It absolutely can. In fact, the US Treasury yield curve has inverted at least ten times in the last fifty years.
What causes the yield curve to invert?
This is a very complicated question. In general, one could conclude that the market predicts more accommodative monetary policy in the future than there is currently. In the US, monetary policy is controlled by the Federal Reserve Bank (The Fed) through various tools available. An inversion would indicate the market predicts Fed policy to be significantly more accommodative in the future (say ten years from now) than today. There are other factors that may influence the yield curve that are much more nuanced and complex.
Why do people care?
An inversion in the yield curve in the US (specifically the two and ten year treasury spread) has predicted every recession in the US economy since 1955. It is seen as a fairly reliable indicator of a looming recession in the US Economy.
Are we headed for a recession?
Not necessarily. It has been said that the four most expensive words in investing are “this time is different”, however, it may be different this time. While an inversion has had strong correlation with recessions in recent history, we’ve never had a time where markets have had negative central bank rates across the world. Certainly we can view it as a flashing warning light on our dashboard and a reason to ensure that our investments are in-line with our risk tolerance, time horizons and liquidity needs. According to a recent study by Credit Suisse, the onset of a recession averages about twenty two months after the initial inversion of the curve with the peak of the S&P 500 occurring on average roughly four months prior to that.
Does the inverted yield curve present any opportunities?
An inverted yield curve is not all doom and gloom, in fact for some people it is the perfect opportunity to refinance or take out a new mortgage. As long-term interest rates plummet, so do mortgage rates. 15, 20 and 30 year fixed rate mortgages start looking very attractive compared to their adjustable rate mortgage (ARMs) counterparts which benchmark their rates off of short term interest rates.
