What is an "Inverted Yield Curve" and Why Should I Care?
What is the inverted yield curve and why should investors care? How does the yield curve affect you if you’re invested in real estate, stock market, precious metals, have a job, own a business?
If you are INVESTOR and not a SPECULATOR, you need to understand what you’re talking about and not be swayed by hoopla and biased interpretations of talking heads with ulterior motives. For this reason, we must first understand what is an inverted yield curve and why it might or might not be a valid predictor of a recession. Only then can we address what type of investments are more sensitive and less sensitive to recession. In this article, we will explain what are treasury bonds, notes and bills, then we will describe what is a yield curve, what is an inverted yield curve and how well does it predict a recession.
Next month, we will address what the inverted yield curve may mean for investors like you, especially since different investment vehicles have different sensitivities to recession. For now, I refer you to the end of this article in which I will give you a hint of my thoughts on this.
What are Treasury Bonds, Notes and Bills?
The US federal government borrows money to fund its operations. Obviously, the taxes we pay are not enough to pay for our government’s efficient and responsible spending! The way the government borrows money through treasury bonds, notes and bills is by selling them to anyone or any entity that wants to buy them in return for the promise that the US government will redeem the bond, note or bill at a later date, plus interest at some interest rate.
Since the US government is considered very stable and reliable, investing in treasury bonds, notes and bills is considered a very safe investment with almost no risk since the risk is that the US government will fail to pay its obligations, which has never happened (yet, at least). That is why you hear the phrase “backed by the full faith and credit” of the US government.
Of course, since the investment in a US government backed treasury bond, note or bill is so safe, the interest rates paid are low, much lower than other investments with higher risk. In addition, investment in treasury bonds, notes and bills is passive…as passive as it gets.
The difference between treasury bonds, notes and bills is simply the term of the investment. A treasury bond matures in 30 years. Treasury notes are issued for 2 years to 10 years. Treasury bills are issued for a year or less and the 3-month bill is widely tracked for reasons that will be explained below.
What is “Flight to Safety?”
As we all know, the stock market can go up or down at any time and sometimes the fluctuations are quite sharp. Individual stocks can even go to zero, like Lehman Brothers in 2008 or Enron in 2002 (Enron went from $90 per share on 8/23/2000 to 12 cents per share on 1/11/2002). That is scary and can even be devastating.
When investors are afraid they may lose money, many figure that it’s better to not make much money than it is to lose money. That is why jittery investors in the stock market sell stocks if they think they might lose and then they park the money in bonds/notes/bills that have low but positive yields. Some may even store the money temporarily in cash since the value of cash erodes by inflation. Inflation has been low for quite a few years, so some investors keep cash on the sidelines, for limited periods of time sometimes, ready for deployment if they perceive the market may go up.
The shift from stocks to bonds is called “flight to safety.”
The Bond Market and What It Teaches Us
When a US government bond is issued, it sells it at auction and we won’t go into the details here since there are different types of bids (competitive and non-competitive), different maturities (as discussed above) and other different mechanisms. The bids are sealed so it’s not like an auctioneer is yelling out numbers at Sotheby’s or on the TV show Storage Wars (no one is yelling yuuup). The final price, discount rate, and yield are released to the public within two hours of the auction.
It is interesting when you realize that when investors get nervous about the ability of US government to make good on its payments, there is less demand for the bonds at auction and that affects the final price, discount rate and yield.
As an aside, the US national debt today (Aug 29, 2019) is $22.55 trillion (if you are mesmerized by numbers changing, watch the national debt clock at https://www.usdebtclock.org/. In May 2019, China owned $1.1 trillion of this debt, bought as US treasuries. Ten years ago in 2009, China owned about $550 billion of US treasuries and the national debt was about $10.6 trillion.
After the auction, the bonds are traded on a decentralized over-the-counter (OTC) market. This is a very crucial point because, in theory, the bond market is determined by a very large number of trades that are mostly independent of each other (though not totally independent because of the Federal Reserve’s influence on interest rates). That’s when things get much more interesting for people who are trying to gauge where the economy is going.
There is huge learning value when a whole bunch of people, including experts, non-experts and self-delusional pseudo-experts, put their money where their mouth is.
When this aggregate of mostly independent decision makers thinks that the economy is going well, they have less interest in bonds and buy into investments that they perceive will have a higher yield (return on investment) since they feel that the risk is lower when the economy is going gangbusters.
When this aggregate of mostly independent decision makers get nervous about the economy, the flight to safety kicks in.
There is one big caveat to everything written in the preceding paragraphs and that is that interest rates have a big effect on the bond market. The Federal Reserve determines the federal funds rate (the rate banks charge each other for special overnight loans). The prime rate is the federal funds rate plus 3% and the prime rate affects all kinds of interest rates that are used when we cycle money through the economy in the form of home mortgages, car loans, commercial loans and more. Keep in mind that when the Fed plays with the federal fund rate, the bond market fundamentals must adjust. For the purpose of this discussion, we will ignore the effect of interest rates on the yields of treasuries, even though the effect is very significant. We can learn from this discussion even when the Fed is not playing with interest rates.
When the economy is going well, investors have little desire or incentive to lend money for 91-days to the US government for a piddly return on investment. As a result, when few people/institutions are buying short term 3-month T-bills, their price goes up. That means that there is less money to be made at maturity since the ultimate interest to be paid is set at auction, so the yield goes down. When price is high, return on investment is low.
For that reason, the yield on short term notes, like the 3-month treasury bill is low when the economy is cruising along nicely. How insignificant is the yield on the 3-month T-bill when the economy is going gangbusters? Five years ago today, the yield on the 3-month T-bill was only 0.03% on 8/29/2014 and only 0.06% on 8/28/2015. Today is 8/29/2019 and the yield on the 3-month T-bill is 1.99%. That is a huge difference.
What is an Inverted Yield Curve?
In a “normal” yield curve, the yields of longer term treasuries are higher than shorter term treasuries. If we look at the treasury yields exactly 5 years ago on August 29, 2014, we see a normal yield curve. This normal yield curve on August 29, 2014 is shown in the red line in the graph below. Pay special attention to the very low yield of the 3-month T-bill and the much higher yield of the 10-year note, both of which are highlighted in a brown circle.
An inverted yield curve happens when the yield on short term treasuries is higher than the yield on long term treasuries.
The yield curve for today, August 29, 2019 is shown in the blue line in the graph. Pay special attention to the higher yield of the 3-month T-bill relative to the yield of the 10-year note, both of which are highlighted in a green circle.
What’s the big deal and why all the nervousness?
An inverted yield curve has indicated a worsening economic situation in the future for ALL 7 recessions since 1970, as shown in the next figure. This empirical correlation is what is getting everyone nervous.
While one can compare the yields of any two treasuries, special attention is given to the inversion of the yield of the 3-month bill to the 10-year note because that is where the correlation with recession is highest.
This is why this measure of the yield curve slope that is the difference between 10-year Treasury note rate and the 3-month Treasury bill rate, is included in the Financial Stress Index published by the St. Louis Fed. This metric is a big deal.
However, just because every time there is a thunderstorm, you see dark clouds, that does not mean that every time you see dark clouds, there will be a thunderstorm (some of you may have to read that sentence again until it sinks in).
So, when you look at the graph, there were several times when the probability of a recession increased, but a recession didn’t happen.
When looking at the unambiguous yield inversion between the 3-month and the 10-year that has been going on for about a month now (the 2-year and the 5-year were inverted earlier than that), the question must absolutely be asked, ‘are we headed for a recession?’
The answer is that we don’t know for sure.
We are experiencing a rare 10 years continuous growth. Unemployment is unusually low. Inflation is unusually low. Interest rates are unusually low. The stock market is near its all-time high. The growth started after the second year of the Obama administration and continues until today.
Of course, you can make the case that things can’t get much better for these key economic indicators. If so, then things can only get worse and maybe that means recession.
Then again, what kind of recession would we be talking about? Recession is defined as negative growth of GDP in two consecutive quarters. That doesn’t say HOW MUCH negative growth, since any negative growth in GDP counts. If the economy is so great right now, maybe the recession will be quite mild (unless trade wars or geopolitical factors get really bad).
If you are still reading this long boring article, it’s maybe because you wondered about the mysterious terminology being thrown around by talking heads called the inverted yield curve. However, I am guessing that you are still reading this long boring article because you are trying to figure out how this will affect your investment decisions.
Next month (or in a later issue depending on how much time I have next month…remember my primary occupation is in the chemical industry and I am fortunate to have a lot of solid work), we will cover the thought processes relevant to which types of investments have a higher probability of weathering a downturn in the economy.
At the beginning of this article, I promised you a hint. Here it is. I will say that, in my never humble opinion, if you have rental real estate with solid cash flow and a high enough debt service coverage ratio to the point that you have the freedom to choose to “hold ‘em or fold ‘em,” you are much more likely to weather a downturn than if you are invested 100% in the stock market going into the downturn.
Stay tuned for a more detailed opinion in the future.
As always, do not make any investment decisions or take any action based in whole or in part on the content of this article. Also remember that every investor’s situation is different, so what may be good for me in my situation may not be good for you in your situation. That is another reason why you must consult with the most relevant licensed professionals you can find and explain your unique personal situation to them before taking action.