Everything you Need to Know about the Yield Curve
The yield curve made headlines last week with the inversion of the 2-year and 5-year government bonds followed by murmurs of a coming recession. With U.S. markets flashing red and the major indexes entering bear market prices, here is everything you need to know about the yield curve and why this seemingly arcane measure is so important for the economy.
The yield curve explained
The yield curve plots the return on government bonds with different maturities, or pay-back dates. It starts with a 30-day Treasury Bill, and extends all the way out to the 30-year Treasury Bond. The different yields represent the return investors would get if they buy a US Treasury with a given maturity today, and hold it until is it repaid by the government at said maturity.
For example, in the yield curve below from August 1, 2015, investors would get 0.3% for the one year if they bought a bond with a 1-year maturity, but 2.9% per year if they bought a bond with a 30-year maturity. It is important to realize that these yields are per year for the life of the Treasury.
How the shape of the yield curve is determined
Starting on the left hand side of the yield curve, shorter maturities represent the minimum return investors are willing to accept for a short term, risk free investment. These rates are determined by the state of the local and global economies, summarized by a variety of macroeconomic indicators, and is closely linked to the Federal Reserve’s Funds Rate.
As we move into longer maturities (right along the yield curve), a number of other factors begin to affect the yields:
- Term premium: typically, investors seek a higher rate of return for longer investments. The longer the money is locked away, the greater the return. This make sense intuitively, and reflects the notion that circumstances may change, and thus longer term investments need to reflect the opportunity cost of locking up money for a long period. Alone, this would cause the yield curve to slope upward as longer investments require a higher return.
- Expectation of future Fed Fund Rate: as we discussed above, the Fed’s policy has a great impact on short term interest rates. Expectations of short term rates in turn influence longer term rates, since if one believes short term rates will go up (down) in the future, one would request a higher (lower) return for a longer lockup. An example here is helpful: if the Fed’s fund rate today is 2%, and one expects the rate next year to be 3%, the minimum one should accept for a 2-year lockup today is (1+2%) x (1+3%) = (1+2.5%)², or, 2.5% per year.
- Expectations of inflation: investors adjust their required return to their expectations about inflation. If one expects inflation in the future to be higher (lower) than it is today, then they will require a higher (lower) rate of return on an investment locked up for a longer period of time. Inflation expectations in the modern economy are typically in the 1–3% range, although they have been lower since the financial crisis of 2008.
The upward sloping yield curve
Throughout most of the economic cycle, the yield curve is upward sloping. This represents the term premium, and in early stages of the economic cycle, the expectation of future Fed interest rate hikes and increasing inflation. This is the state of the August 2015 yield curve above.
While the short end of the yield curve can be manipulated by the Fed’s activity, the further out we go on the curve, the less impact the Fed’s current and expected behavior has the yields. At the furthest end of the curve, the yield is impacted by longer term expectations of inflation and financial growth. For this reason, the far end of the curve is typically more stable.
The inverted yield curve
An inverted yield curve occurs when longer interest rates are lower than short term interest rates. Investors often compare the yield on the 2-year and 10-year government bonds, but an inversion can happen between any two points on the curve. As of last week, an investor received a lower return on a 5-year government bond, than on a 2-year bond. Why would this be the case?
Recall from above that the yield curve incorporates the expectations of short term interest rates, and implicitly, the future (or forward) Fed’s Fund Rate. If investors think that in 2 years short-term interest rates will be lower than they are today, they would be willing to accept a lower interest rate for a 5 year lockup.
A crude mathematic illustration using today’s yield curve would be as following:
(1+2.67%)² x (1+2.63%)³ = (1+ 2.65%)⁵
Or in words, if I think the 3-year rate, two years from now will be 2.63%, lower than today’s 2-year rate of 2.67%, than for a 5-year lockup, I would only require a return of 2.65%, also lower than today’s 2-year rate.
In essence, an inverted yield curve reflects expectations of lower interest rates, likely due to Fed expansionary monetary policy, which is what happens during recessions. The Fed Funds Rate is the primary tool the Fed uses to stimulate or cool down the economy. In a recession, the Fed lowers the rates in order to lower borrowing costs and stimulate economic growth.
Historically, the yield curve has been a reliable tool for predicting recessions. Starting in 1976 on the chart below, every time the price of the 10-year bond dipped below that of a 2-year bond, the classic yield curve inversion, a recession followed. Furthermore, every recession was preceded by an inverted yield curve, typically 6–12 months before the recession.
Today’s yield curve
Today’s yield curve is essentially flat, with a small dip in the belly around the 5-year term. This strange shape is a result of multiple factors:
- Fed policy. On the short end of the curve, the Fed has been raising its Funds Rate, and is expected to continue doing so, though as they indicated on Wednesday, possibly at a slower pace. This causes the short end of the curve to rise and slope upward. On the longer end of the curve, the Fed’s Quantitative Easing (QE) positions continue to keep long term rates low. Recall that QE, a mass purchase of long term bonds by the Fed in an attempt to lower interest rates, led to the Fed holding $4.5 trillion in assets on its balance sheet. The Fed has recently started unwinding these positions, but it’s a long process, and the sizable holdings still put downward pressure on the far end of the curve.
- Low inflation. Inflation has been under 2% in the last 6 out of 10 years, and expectation of future inflation 10 years out, measured as the difference between inflation-protected government bonds and regular 10-year bonds, recently dipped under 2%. As we discussed above, rising inflation causes investors to seek higher longer term rate, and their absence flattens the curve. Low expectations of inflation are a sign that investors do not expect the economy to stay at full employment for long, as low unemployment rates are associated with rising inflation.
- Economic uncertainty. While the US economy remains strong with unemployment at 3.9% and 4.2% growth in GDP in the first half of the year, there are mounting concerns over how long the economic expansion will last. Economies around the world are already demonstrating signs of a slowdown, and the US stock markets are poised to close the year at a loss for the first time since 2015. As uncertainty mounts, investors seek long term safe returns in treasuries, bringing their price up, and their yield down.
What this means for investors
That the current economic cycle will end is beyond any doubt, the only question is when. A yield curve inversion can be helpful in predicting a recession, but remember:
- The most reliable recession predictor is an inversion in the prices of the 10-year and 2-year bonds, and that has not happened yet
- Today’s yield curve is the outcome of economic forces we’ve never seen before, namely, QE and a very low interest rate environment for many years. It’s possible that these dynamics upset the effectiveness of the yield curve as a recession predictor
- Even after an inversion, and assuming the inversion correctly predicts a recession, we are still left with a window of 6–12 months for the recession to hit
With all this uncertainty, you might be tempted to stash your money under your mattress. However, it’s worth remembering that on average, a bull market goes up 6.6% in its last year. Here is how investors can use this information.
- Make sure your portfolio allocations match your capital needs. This is true always, but especially in times of volatile markets. If you have 30 years before you retire, one market correction will likely have a small impact on your overall finances. If you’re retiring in 5–10 years, that’s a whole different story.
- Diversify. Diversification is still the best way to lower portfolio volatility. Want a smoother ride though the coming turmoil? Diversify. Bonds are a good start, but real uncorrelated assets are easier to find in the private markets.
- Make sure you have dry powder. When stocks are cheap, that’s the time to buy. While it’s virtually impossible to identify the bottom of the market ex-ante, a patient investor can find good deals on equities in the aftermath of a market correction.
- Be cautious, but not panicked. No one knows how things are going to play out. Once you’ve used the steps above to prepare, take a step back and don’t check your portfolio every day. From the top of the market in January 2008, it took the S&P 500 less than 5 years to regain everything it had lost. While such a speedy recovery is not guaranteed, remember, this too shall pass.