What is the Yield Curve all about?
If you are into trading in debt then yield curve is staple diet, just like P/E ratios are for equity investors. But the yield curve also has a larger macro implication. The yield curve measures the relationship between time to maturity and risk. Normally, the 10-year bond is taken as the benchmark to plot the yield curve and this is a practice across the world. So if you take the X-axis of the yield curve you start with a 1-year bond and then go all the way towards a 30-year bond. As bond maturity increases, the risk increases and therefore investors demand higher return. That means the yield curve should typically have an upward slope; 10 year bond has a higher yield than a 2-year bond and a 30 year bond has a higher yield than a 10 year bond. That is what an inverted curve is all about and in normal conditions the yield curve always has a positive slope.
An inverted yield curve is not necessarily inverted
To begin with, an inversion of the yield curve does not mean that the yield curve slopes downward. The shape may get slightly distorted but inversion has a different connotation as captured by the graph above. To measure yield curve inversion, the spread between the yield on 10-year US bonds and 3-month treasuries is considered. Ideally, the 10 year bond should quote at a premium to the 3-month treasury. That means the spread should be positive. However, whenever the yield on 10-year bonds goes below the yield on 3-month treasuries (spreads become negative), it is considered to be an inverted yield curve.
In the above chart, the light purple line shows the yield spread (10-year bond yield minus 3-month treasury yields). Each time the spread becomes negative, it is shaded in dark purple. What is more interesting is that in the last 50 years, whenever the yield curve has inverted it has been followed by a recession. The last two inversions, of course, happened after the tech crisis in 2000 and during the sub-prime crisis in 2007. The thickness of the grey shade captures the length and extent of recession.
So yield curve inversion indicates a recession, but why?
If you see the last two occasions when the yield curve inverted in 2000 and 2007, the cuts in the US equity markets were huge and even Indian markets lost as much as 65% in 2007. But, what is this relation between yield curve inversion and a growth slowdown?
- Yield curve inversion shows an absolute aversion to buy long dated debt. That is a lead indicator that the markets are anticipating pressure on long term yields.
- Business confidence could be low, which explains why most investors prefer to buy debt at the short end of maturity rather than at the long end.
- Due to uncertainty at the long end, governments and corporations also prefer raising money with short term paper. There is too much yield uncertainty over the long term.
- A quick glance at the US yield curve chart tells you that an inversion of the yield curve is invariably followed by a recession. With the yield curve again inverting in 2019, what does it hold for global growth and what does it mean for India.
Any inversion of yield curve is time to be cautious; not essentially recession
If empirical data is anything to go by then every yield curve inversion in the last 50 years has been followed by a growth slowdown. That is why the inversion of yield curve is at the centre of the debate today. But there is a big difference between the previous inversions and the current inversion of the yield curve. That difference is the quantum of negative yield debt in the world (yes you pay to invest).
- Negative yielding debt that was virtually zero in 2014 has growth to $15 trillion in 2019. This is important to our understanding of the inverted yield curve. Here is why.
- The traditional yield curve definition is based on the assumption that yields are positive. Instead, when you pay to invest and accept negative yields ($15 trillion is not small by any measure), the yield curve targets distorted.
- Secondly, central banks globally prefer to have negative yields when their currencies are treated as safe haven currencies. SFR and JPY are cases in point where bond yields are negative. In such cases, negative yields become a defence against currency wars.
Sir John Templeton once said that the most dangerous four words in financial markets are “This time it is different”. But this time around the inversion story actually looks to be different. Eventually whether we end up with a recession or not; only time will tell.