If you have been keeping up with the financial press, you have undoubtedly heard about the yield curve inversion. This somewhat technical sounding phenomenon is actually a very simple concept with profound implications for markets, which is why a solid understanding of what we’re talking about is essential for developing a view of future asset performance.
Just like some stocks have dividends, bonds have yields. As debts which promise to pay a certain interest rate (called a “coupon”), bonds give creditors (also called “bondholders”) a steady and pre-planned amount of interest to compensate them for lending money. This is known as the “yield,” and it’s calculated simply as the annual interest payments divided by the principal. If a $100 bond pays out $2.00 in interest payments to bondholders, the bond yield is $2/$100, or 2%.
Different durations of bonds have different yields. For instance, if a company (or government) borrows money and promises to pay back in 2 years, it will pay a different yield than if it borrows and promises to pay back in 10 years. This makes sense, because of the concept of the liquidity premium. An asset that converts to cash faster than one that doesn’t will have a higher value, so bondholders can tolerate a lower yield on shorter term bonds, because those bonds will convert to cash faster.
When we discuss the difference in yields between various bonds from the same debtor at different durations, we are talking about a yield curve. The U.S. Treasury borrows bonds at durations ranging from 1 month to 30 years, and the different yields on all of those bonds can be plotted out to create a chart. This is the yield curve.
Since shorter term bonds are more liquid, they typically will have lower yields. But sometimes they will have bigger yields—and this is known as an inverted yield curve.
This is what has made the press. At the end of last week the yields for the U.S. Treasury saw the following yields:
|Date||1 Mo||2 Mo||3 Mo||6 Mo||1 Yr||2 Yr||3 Yr||5 Yr||7 Yr||10 Yr||20 Yr||30 Yr|
Note how the 1 month is the biggest yield of them all, despite being the shortest duration! There are many points in this yield curve where shorter duration yield more than longer duration. This is known as an inverted yield curve, because the yields are not what one would expect from normal liquidity preferences.
The reasons why this has happened to U.S. Treasuries are complicated and controversial. But every time the 2 year and the 10 year yields inverted in U.S. history for a long period, a recession followed within 18 months. Note the caveat: “for a long period”. In the mid-90s a brief inversion did not result in a recession until a second inversion happened, which has raised questions over whether this inversion means a recession is coming or not.
To understand whether this is a leading indicator or not, it’s important to understand how Treasuries are used in the market and what aspects of the financial sector are negatively impacted by an inverted yield curve. These are complex topics that deserve their own attention, but needless to say: a yield curve inversion on its own, while worrisome, is not enough to produce a definitive conclusion about the U.S. economy or the future of capital markets.