Yield Curve

Probably one of the most searched terms this month was “yield curve” and amid fluctuations in the markets, I wanted to contribute to the community by explaining the subject in a nutshell and providing visual evidence to make it clear for the ones who are interested in the issue. In order to keep it simple, I did not elaborate the subject in academic level, but I still kept the essentials intact. 

Although the discussion about recession and inverted yield curve was prevalent topic in financial circles, since the last quarter of 2018, central banks managed to change the perception by denying it and promising to support economies in such a scenario via quantitative easing. And that was an enough reason for a bullish rally on all the markets. However on the other side of the coin, including but not limited to; trade tariffs set by USA, retaliation by China and currency wars led by devaluation of Renminbi, tensions on the Gulf by the Strait of Hormuz, slowing economic growth and race to the bottom on interest rate cuts by central banks tell another story. Which, in turn, is reflected to US government bond yields and caused an inverted yield curve in time. That is widely interpreted by the actors as a signal of approaching recession. So, let us shed light on the topics step by step:

What is yield curve?

According to Mishkin, “A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations is called a yield curve, and it describes the term structure of interest rates for particular types of bonds, such as government bonds.”  

With this definition I plot all available US Treasury securities of various maturities from 1 month to 30 years on the horizontal axis, with their interest rates indicated on the vertical axis. In order to get a better idea, I have three different time points selected as: Beginning of the year (blue), mid-year (green) and yesterday (yellow),  For example, the yield curve named “Aug 28” shows that the interest rate on the three-month Treasury bill was yesterday 1,99 percent, while the one-year bill had an interest rate of 1,74 percent and the five-year bond had an interest rate of 1,37 percent.

Connecting these three figures show that the yield curve has a downward slop, which is contrary to normal circumstances. But beyond 5 years for “Aug 28” yield curve again takes its typical form with an upward slope. As the future is unknown, long term investments bear a higher risk and therefore a higher cost than short ones. Furthermore, due to inflation in the long-run, fixed returns do not worth that much compared to short-term alternatives. With these reasons yield curve tend to slope upward. Another point to pay attention on the above graph is, that interest rates are falling for all securities from the beginning of the year, and particularly since June.  

Here on the second graph I have also plotted two, ten and thirty-year bonds (respectively yellow, green and blue) for the whole year of 2019 until today. A couple of things are striking: First of all, interest rates were flat until March, but since then constantly falling. Secondly, long-term securities are in high demand compared to short-terms. Thirdly, the gap between those two are closing and two-year Treasury bond pays more than ten-year bond, as indicated with the arrow. So are we in recession?  

What is recession?

If quarterly GDP growth rate in an economy declines two times in a row, it is called a “contraction“; but if that slowdown occurs at the below zero line, that economy is called to get in a “recession”. Although economic data at the moment do not match to this allegation, market expectations and inverted yield curve suggest it strongly.

Recession and the yield curve

As the bond market brings the demand for loanable funds together with the supply of those, market interest rate for these securities give a glimpse of actors expectations about the current and future situation. If the economy is growing around/over its capacity, and there is a demand or cost related inflation pressure, actors reflect these expectations, also bound with risks, on their demand for long-term bonds as a higher interest rate. That is the essential reason behind the long-term and short-term yields difference. In such a case, FED increases the interest rates to fight with inflation by slowing down the demand. Due to increased short-term yields, the premium for investing in longer-dated yields declines. From the graph, we can see that FED kept the Federal Funds Rate constant at 2,50% since the beginning of the year and made a quarter of a percent cut in the last meeting. From their perspective and given mandate things seem under control, but needed to be handled gently. We will probably see a fifty basis point cut at the next meeting, but not alarm rings. 

Inverted yield curve

If the situation is just the contrary of above explained, which can be depicted as a sluggish demand, slowing economy, than FED might decide to cut rates in order to stipulate demand and production with lower borrowing costs. In order to make such decisions, among other things, FED observes yield curve closely. And the strongest indicator for that is the difference between two-year and ten-year Treasury yields. On 19th of August, the difference between those two drifted to negative zone, first time since 2007. 

And that movement is interpreted by the actors as a sign of recession. Because since 1970’s every touch in the negative zone between two and ten-year bonds spreads was a messenger of a recession, or putting it in another way self-fulfilling prophecy at todays financial world. 

Further Notes:

In such situations investors look for safe assets as gold and bonds to keep their wealth protected against the risks. And that means an increase in the demand for those assets. It is crucial to explain here briefly the mechanism behind price structure and interest rate on bonds: Ceteris paribus, when the demand for bonds increase, the demand curve shifts to the right and consequently the price of bonds increase. As the price of a coupon bond and the yield to maturity are negatively related, an increase in the bond price drive the interest rate down. In this regard, it is also important to keep in mind that the return on a bond will not necessarily equal the interest rate on that bond. Due to an increase on demand, bond price also increases and as a result capital gains occur for purchased bonds, which is basically the difference between bond’s price relative to initial purchase price. Only comparing current yield and capital gains we can reach a conclusion, whether the investment was profitable or not.           

Further Readings:

If you have the advantage of multi-language, than I recommend you to read Mahfi Egilmez’s article on the issue, even before this topic was so popular. It is dated back to 2014 and includes a practical application of this framework to Turkish economy.

For the economic data you can visit the website of the U.S. Department of Treasury and create your own graphs.

For the loanable funds framework, bond pricing and capital-asset-pricing model Frederic S. Mishkin’s The Economics of Money, Banking and Financial Markets is the best.

And another source for interested here is an article from Financial Times.

Ergun UNUTMAZ, 29.08.2019