The Predictive Powers of the Yield Curve
When markets get shaky investors and economists start talking about the yield curve because they might not have a crystal ball, but the yield curve is the next best thing.
What is the yield curve?
To understand the yield curve, we first need to understand bonds. Bonds are one of the safest investments in the market and are staples of many investment portfolios, from pension funds to retirement accounts. A bond is a chunk of money an investor lends to a company or a government with the agreement that over time they’ll be repaid with interest. The amount of money an investor gets back from a bond's coupon (interest) payments is known as the yield.
The bond market, rather than its volatile cousin, the stock market, is thought to be a stronger gauge of the economy. The yield curve's behaviour is constantly monitored because interest rate movements can reveal a lot about what highly sophisticated institutions think about the economy's future health.
The yield curve measures the yields of all bonds the treasury is selling over a long period of time. The x-axis shows when the bonds will be repaid and the y-axis measures yield, the interest that the bondholders will receive annually.
A normal and healthy, upward-sloping yield curve reflects the fact that short-term interest rates are frequently lower than long-term rates of bonds. Investors and economists look at the way the curve bends to predict the health of the economy. The US yield curve, in particular, operates as the key barometer of investors' profound comprehension about the future path of the world's largest economy and has a solid track record of predicting downturns before they occur, given to the dollar's central position in the global financial system.
An inverted yield curve has always been an omen or the harbinger of recessions. Inversions of the yield curve have historically foreshadowed recessions in the United States. Because of this historical association, the yield curve is frequently used to forecast business cycle turning points.
What causes the yield curve to invert?
There are two levers- the first is the Fed which influences the short-term bonds on the left side of the curve. in a booming economy, the Fed raises the short-term interest rates to limit inflation which can get out of hand when too many people are borrowing and the economic growth is moving too quickly. However, when the economy is stagnant, the Fed often lowers the rates to encourage borrowings. The Federal Reserve recently raised interest rates for the first time in more than three years, an incremental salvo to combat soaring inflation without jeopardizing economic growth.
Investor sentiment controls the right side of the curve. When investors think that the economy is in a good shape, they take money out of the long-term bonds and instead pour their money into riskier assets like stocks. The lower demand causes the price of bonds to sink, pushing up the yield curve reflecting that the price of a bond is inversely related to the yield. Hence, when the bond prices sink, the yields rise and vice versa. But when the investors think that the economy is headed for a rough patch, they pull their money out of stocks and put it somewhere safer like long-term bonds, and this causes the yields to drop. Therefore, when short-term interest rates go up and investor sentiment goes down, the yield curve starts to flatten and can eventually invert.
How do negative yields work?
The yield is the calculation of how much an investor can expect to make from holding onto a bond bought at a particular price for a particular length of time. When the bond market is experiencing unusually high demand due to investor sentiment or when the central banks around the world set their interest rates below zero. Central banks are banks for commercial banks. Hence, when they set negative interest rates, commercial banks must pay them for the privilege of holding their money. This further incentivises the commercial banks to lower the interest rates they charge to average consumers. Negative interest rates incite the investors to buy bonds rather than pouring their money at a bank. This drives up the demand for the bonds and drives down the yields, so much that they reach the negative territory. The million-dollar question is this: Wouldn't it be safer for investors to keep their money under their pillows rather than invest in bonds with negative yields?
but If the demand continues to rise, buying now means potentially selling bonds later at a higher price. This can help offset losses in the short run but the long-term implications of negative yields could mean lower returns on retirement accounts and pension funds, meaning workers would have to save more and work longer. Negative bond yields and negative interest rates are, therefore, are viewed as short-term remedies to get the economies moving.
What has been happening with the yield curve more recently?
The US yield curve reversed in 2019, raising concerns that the extended economic growth that followed the global financial crisis was coming to an end.
When the Covid epidemic forced the closing of large sections of the global economy, the result was a recession. Even the most ardent supporters of the yield curve do not claim that it can predict pandemics. Still, we'll never know if the US was on the verge of a recession, and the predictive potential of inversions has maintained its great record.
Short-term government bond yields have risen rapidly this year, indicating anticipation of a series of rate hikes by the US Federal Reserve, while longer-term government bond yields have risen more slowly, owing to concerns that policy tightening could harm the economy. As a result, the Treasury yield curve has been flattening in general and hinting toward a recession.
Whether or not that turns out to be correct, financial market clairvoyants are likely to keep staring at the yield curve.
However, it is important to remember that the use of yield curves as an economic harbinger can be both confusing and scary to an average investor. When the media proclaims that the sky is falling because of flat or inverted yield curves, or that the economy is booming because of a steep yield curve, it's crucial to remember that this is just a glimpse. The yield curve is an indicator, not a forecast. Treating the yield curve as a single piece of data rather than a perfect forecast of the economy as a whole can assist investors in making the best investing decisions possible.
Authors: Madhav Goel and Aagya Mehta
Illustration by: Arab Kansal and Shubham Kandoi