WTF is: Inverted Yield Curve?

WTF are terms used in this post?

Treasuries: U.S. bonds or debt sold by the federal government that pays fixed interest payments. Buying a treasury is like “loaning” the U.S. government money. Contracts range from one month to 30 years. These are considered the world’s safest securities as they are backed by the credit of the U.S. government which has the power to easily raise money through taxes.

Yields: The % of the annualized rate of return you can expect to receive on investment in bonds or T-bills

Maturity: The date or length at which the bond expires.

WTF is an Inverted Yield Curve?

Investopedia properly defines it:

An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.

(Reuters) – The inversion of the U.S. Treasury yield curve extended to 3-month bills for the first time since 2007. Here is what that means.

An inverted yield curve has yields fall as maturity rises

Why does this matter? 

In normal circumstances, it would be quite intuitive to assume that a loan that is held for a longer time will return higher %. Imagine I ask to borrow $10 for you every week, and every Friday I’d return $11 to give you a 10% gain. Now, what if I asked to instead borrow $50, and offered to give you back $55 at the end of five weeks? Well, it’s the same return of 10%, but you’d probably rather take the first option because it only binds your money up in $10 increments, which leaves you the other $40 to do whatever you want with. There is an opportunity cost of lending someone money. This basic premise allows us to understand that longer-term bonds will generally yield higher returns than shorter-term loans.

In terms of these T-Bills and bonds, we are talking about trillions of dollars bounded up in issued contracts by institutions, government, and corporations. Hedge funds, mutual funds, and individuals like you are me are the ones who own these contracts. So it’s important that we understand that a normal yield curve should have higher yields with a longer maturity.

A normal yield curve has higher yields for longer holding periods

Looming Recession?

December 3, 2018, the Treasury yield curve inverted for the first time since the recession.

The Treasury yield curve inverted before the recessions of 2001, 1991, and 1981.

The yield curve also predicted the 2008 financial crisis two years earlier. The first inversion occurred on December 22, 2005. 

Let me explain what this means for investors by using some basic economics. The reason the yield on certain debt (T-bills or bonds) will drop is because of an increase in demand. The increase in demand will make the face value of the bond (the price you “pay”) for the right to that contract go up. If demand increases and investors flock to longer 10-year bonds, the yield on these longer-term debt contracts don’t need to be as high because the demand is high enough that some investors will settle for a lower yield. This means that shorter-term debt contracts, like 3-mo

nth bonds, will need to make their yield % higher if corporations, companies, or governments want to actually get people to loan them money. So as more people buy longer-term bonds, shorter-term bonds will rise in yield, and this is how we get the inverted yield curve.

Normally, shorter-term bonds should return a lower %. After all, if you are only lending someone money for 3-months, they have less time to actually do anything with that money compared to someone who can hold your money for 10-years and actually maybe build a business and return some higher profits. Now, with the inverted yield curve, investors are signaling that short

-term duration prospects are not as confident. Investors would rather lock-in longer-term bonds, 5-years, 10-years, because they think that in the short-term, a recession is likely. A recession in the economy will last on average 18-months.

Again, this is basic intuition. Imagine that as soon as you finish reading this post, you believe correctly that a recession will start. Well, even if shorter-term bonds can offer you a higher return, let’s say 5%, you don’t want to buy too many of those. Instead, since you think the stock market will soon drop, you’d rather take a more modest 3% return that might be 3-years long so you can protect yourself for the next 18-months when stocks do crash during a recession. 

Key things to note:

• Generally, an inverted yield curve signals a potential recession that will occur anywhere in the next 12 to 24 months.
• The inversion does not predict the severity of a pullback in the economy
• The inversion will generally end BEFORE the recession begins

Panic… or?

Now I don’t really think there’s any reason to panic right now (never panic as an investor), but investors do need to be wary and it might be a smart idea to shift some of the weight of your portfolio from risky stocks to safer “recession” proof stocks–consumer staples and health care industries are generally on the safer side of investable companies. Think McDonalds and JnJ. People will always eat Big Macs and need Band-Aids.

Please remember that the inverted yield is just one of many indicators of how well the U.S. economy is doing. Though it is important to be wary. The FED also noted that there would likely be no more hike rates in 2019. In 2005, when the yield first inverted, stocks still managed a strong push upwards for a few years.

Corporate profits and earnings are still coming in strong. Unemployment is still low. Sino-US trade war talks are making progress. Debt is rising, but it’s been somewhat manageable.

In the global economy, Brexit and Venezuela seem to be in the news every day, while China’s economy has been slowing down for the past few years as well. America doesn’t look too bad compared to the rest of the world.

Written March 29th, 2019

 

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