The Yield Curve Inverted, So What?

Stropro Team
Stropro
Published in
6 min readApr 5, 2022

Yield Curve 101:

While my colleagues both past and present know I love detail. I’m going to try to keep this one simple/educational. Those looking for a detailed analysis should check out this Bloomberg opinion piece from John Authers.

Now excuse me while I attempt to oversimplify the dynamics of one of the most important and complex financial instruments in the world.

Glossary: Bonds, Yields and Interest rates:

I’m sure most readers already understand these concepts, but I remember when I first learned about the yield curve in ECON101 I got a little confused, so if I can save someone else that confusion I’m happy.

  • Treasury Bonds*: Buyers of treasury bonds lend the US government money, they then receive an interest rate over the bond term and their capital at maturity. Everyone likes these bonds because they’re almost 100% confident that the US Government will pay back its debt.

*For simplicity, I have grouped all US Fixed Income Treasury Securities into the word ‘Bonds’ which are defined as long term (20/30-years). Short-term instruments are known as ‘bills’ and mid-term are known as ‘notes.’

  • Interest Rate: The interest rate is the rate of return a Treasury Bond pays on its face value (original purchase price). The rate is set when it’s auctioned by the US government each month. To oversimplify it, investors essentially ‘Bid’ for the rate they’re willing to pay.
  • Yield: The yield is the return expected to be ‘generated’ by the bond up until maturity. This is a function of the interest rate and price of the bond. Assuming the same interest rate, a more expensive bond will have a lower yield than a cheaper bond. It generates less return per dollar spent.

As you read this article remember that yields go down because the price (demand) for that bond is high.

What is the yield curve?

The yield curve is the visual representation of the yield on a bond that an investor can achieve at each term length. Below is an example representation.

Any debt instrument can have a yield curve, but the big one of course relates to the world’s reserve currency — US Treasury yields.

What does the Treasury yield curve tell us?

Very simply, the yield curve tells us the market’s expectation of interest rates over the various terms. Consider it an accumulation of ‘bets’ (researched investment decisions) on what the interest rate will be at each maturity term.

Generally, longer-term yields are typically higher than short term yields. This is because there is more risk (i.e. inflation) over longer periods of time, so investors demand a higher return to offset that risk. This environment is reflected in the example curve above.

Recently the curve has inverted

What does an inverted yield curve mean?

An ‘inversion’ of the yield curve is the phenomenon where the yields on long-duration bonds are lower than on short-duration bonds. This means that markets see more risk in the near future than in the longer term.

Historically, a yield curve inversion, where the 10-year yield is less than the 2-year yield (the 2y/10y spread), is viewed as one of the major predictors of a recession in the near-ish future.

The above chart is essentially telling us that markets think that there will be a recession in the near future.

Here’s another oversimplified thought process of a potential market participant.

  1. I’m a US treasury bond trader and I think that there is going to be a recession in the near-ish future.
  2. If there is a recession it will mean the US Federal Reserve has to drop interest rates in order to stimulate economic growth.
  3. If interest rates drop, bond yields will go down.(1)
  4. I don’t want to buy a 2-year bond because when it matures I’d only be able to buy lower yield bonds thanks to the lower interest rates.
  5. I’m willing to pay a premium (receive a lower than typical yield) for a 10-year bond now because I don’t think that I’ll be able to achieve the same or better yield in 2 years’ time.
  6. I buy the 10-year bond and the recession happens and interest rates go up. I’m happy because my bond is more valuable thanks to its higher interest rate. I can now sell this bond for a profit or hold it and receive a better return than what bonds are currently offering.

Ok, so there’s going to be a recession? What strike date should I write for my deeply out of the money S&P 500 puts?

Hold on there Burry, if I knew any of that — I would be dictating this article to my personal assistant while on my Yacht in the Mediterranean.

The headline is that 22 out of 28 ‘2y/10y’ inversions since 1900 have resulted in recessions. Which is some relatively damming, but not conclusive evidence.

The key is to view this inversion not as a golden rule, but as another tool in your toolbox to assess the economic environment. Some economic indicators are all sitting fairly well, and there are talks of positive spreads in other parts of the curve. Still looming are Inflation, commodity and geopolitical issues, and that’s without any CPI data post Russia-Ukraine conflict.

Even if it was the golden rule, the actual question you should care about is ‘When’ is the recession. Of the past 6 recessions, they occurred within 6–36 months of the yield curve inversion. Good luck paying your short interest for that long.

Ultimately, my point is you’re probably not going to time this one. A recession isn’t certain, and the timing after the inversion isn’t certain either. Luckily a good portfolio shouldn’t need to time the market. Keep it simple and maintain a diversified portfolio with a healthy allocation to alternative assets that have low correlations to traditional markets. By the way, Stropro has just listed its first alternate fund manager… just saying.

Written by Rory Turner

(1)Bonds are valued just like stocks, through a discounted cash flow (DCF) model. If interest rates decrease, the future cash flows are now discounted by that new rate. This increases the price of bonds with higher interest rates(as their cash flows are being discounted less). The increased price of course means lower yields.

This article has been prepared by Rory Turner. Rory Turner is an Investment Analyst at Stropro Operations Pty Ltd (ABN 28 633 603 399) (Stropro). This article is for educational purposes and is not a substitute for professional and tailored financial advice. This article expresses the views of the author(s) at a point in time, which may change in the future with no obligation on Stropro or the author to publicly update these views. This article uses information from sources the author considers to be reliable but does not represent that such information is accurate or complete, or that it should be relied upon. Past performance is not a reliable indicator of future performance. Investments may rise and fall in value and returns cannot be guaranteed. Stropro makes no representations or warranties, express or implied, as to the accuracy or completeness of the information it provides. Stropro Operations Pty Ltd (ABN 28 633 603 399) is a Corporate Authorised Representative (CAR №1293257) of Stropro Compliance Pty Ltd (ABN 74 640 214 740, AFSL №533443).

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Stropro Team
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