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