Inverted yield curves are closely being watched. What they say about the economy may have consequences on your wealth and perhaps your spending habits.
Try to recall one of your mornings in mid-July. While sipping your coffee and doing your rounds across your most trusted news sites, you might have encountered articles in the business pages about a yield curve inversion reaching its most extreme level in more than 20 years.
Chances are you tried to read these stories in order to understand why we should care about this phenomenon. What does an inverted yield curve tell us? Why should people care? Let us try to demystify this yield curve.
What is a yield curve?
The yield curve, which you read about in the business sections of newspapers, simply plots the return on all Treasury securities. It typically slopes upward. The yields of short-term securities are lower than those of long-term securities.
That’s because investors want higher returns if they are going to risk their money for longer periods of time. Remember also that yields move inversely to the prices of fixed income securities, since when there is more demand, the Treasury will not have to raise yields to attract investors.
A steepening curve typically signals expectations for stronger economic activity, higher inflation, and higher interest rates. Yields on long-term bonds are rising faster than yields on short-term bonds. This means investors expect better market conditions over the long term.
A flat yield curve, on the other hand, is often seen during the transition from a normal yield curve to an inverted one. Investors expect near-term rate hikes and are pessimistic about economic growth.
What does an inverted yield curve suggest?
Investors watch parts of the yield curve as recession indicators, primarily the two- to 10-year bonds. When short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall.
For example, the yields on the two-year and 10-year Treasury notes have been inverted for more than a month. A deeper yield curve inversion is an expression of investors’ expectations of a recession in the near term. The 10-year Treasury yield stood at 2.688% last August 4, compared to the 2-year Treasury yield of 3.047%, a spread of about 35 basis points (bps).
Yields on US Treasuries have inverted the most since 2000.
Yield curve inversions also suggest that while investors expect higher short-term rates, they are wary of the Fed’s ability to control inflation without hurting economic growth. Even before the summer in the US, the closely watched 2- and 10-year yields inverted several times as the Federal Reserve tightened monetary policy at a pace that may have sparked fears of a recession. The Fed has already raised rates by 150 bps this year, including a jumbo-sized 75-bp increase last June.
Nonetheless, the 8.5% rise in the consumer price index (CPI) in July was perceived as good news for consumers and policymakers, even if high prices for food and rent still pose a challenge for the US government.
Some have also pointed to a strong labor market as a good reason to shrug off fears of a recession. Thus, it is still being debated if the technical recession is really a recession as unemployment remains low and some parts of the economy continue to be strong.
According to a report by Credit Suisse Global Strategy, the 2-year and 10-year yield curve has previously predicted two recession signals in the past 40 years. It has to stay inverted for at least 10 months prior to a recession. This could then lead to a recession within 15 months.
What does an inverted yield curve mean for investors?
Indeed, it is worthwhile to pay attention to the behavior of the yield curve. A yield curve inversion may have a huge impact on fixed income investors. As mentioned earlier, long-term investments have higher yields because investors are risking their money for longer periods of time. An inverted curve eliminates the risk premium for long-term investments, allowing investors to get better returns with short-term investments.
The yield curve also affects consumers and businesses. When short-term rates increase, banks raise benchmark rates for a wide range of consumer and commercial loans, making borrowing more costly for consumers. When the yield curve steepens, banks can borrow at lower rates and lend at higher rates.
GERALDINE WAMBANGCO is a Financial Markets Analyst at the Institutional Investors Coverage Division, Financial Markets Sector, at Metrobank. She provides research and investment insights to high-net-worth clients. She is also a recent graduate of the Bank’s Financial Markets Sector Training Program (FMSTP). She holds a Master’s in Industrial Economics (cum laude) from the University of Asia and the Pacific (UA&P). She takes a liking to history, astronomy, and Korean pop music.