Yielding Clarity

John Lim

THE YIELD CURVE HAS lately received a lot of press. Specifically, the inversion of the yield curve has many people worried that a recession is around the corner. I’ve been spending a lot of time recently thinking about the yield curve. I need to get a life, right?

You may be asking yourself, “Why should I even care about the yield curve, whatever that is?” Here’s why: The yield curve has inverted prior to every U.S. recession since 1970. Check out the chart below from the Federal Reserve Bank of St. Louis.

The shaded bars indicate recessions. The blue line is the difference in yield between 10-year and two-year Treasury notes. When the line goes negative—meaning the 10-year yield is lower than the two-year yield—we have an inverted yield curve. You can see how remarkably accurate the yield curve has been in predicting recessions. It may not be a perfect indicator, but it’s a darn good one—probably the best we have.

There’s always a time lag between when the yield curve inverts and the recessions that follow—sometimes a sizable one. For example, while the yield curve briefly inverted in December 2005, the Great Recession was still two years away. If you had taken a more conservative investment stance at that time, by lightening up on stocks, your patience would have been sorely tested. The S&P 500 would go on to rally another 25%, before it peaked in October 2007—just months before the recession began.

Ultimately, however, your caution would have been rewarded, because you would have sidestepped at least some of the carnage of the horrendous 2007-09 bear market. If you use the yield curve to try to precisely time the stock market, you’re likely to be disappointed. But as the renowned investor Howard Marks likes to say, “While you can’t predict, you can prepare.” I like to think of the inverted yield curve as the prudent investor’s proverbial canary in the coal mine.

What exactly is the yield curve? It simply shows the current interest rate on U.S. government bonds of different maturity. For instance, a typical yield curve might plot five different Treasurys, those maturing in three months, two years, five years, 10 years and 30 years. As a bond’s maturity increases, so too does the yield—usually.

Why is this? Imagine your best friend wants to borrow $1,000 for two weeks, until his next paycheck arrives. Would you charge him interest? Probably not (unless you’re looking for a new best friend). But what if he wanted to borrow $1,000 for 10 years? Hmmm. Why is this different? We all know instinctively that, in 10 years, money won’t buy what it can buy today.

It stands to reason that the longer a bond’s maturity, the more a bondholder needs to be compensated for the risk of inflation, which is public enemy No. 1 for bonds. This compensation takes the form of higher interest rates. In other words, because of inflation, owning a 30-year Treasury is far riskier than owning a two-year Treasury, so the 30-year bond should normally have a higher yield.

What if investors expect inflation to rise? They know that, because most bonds have a fixed payout, those future payouts will have even less spending power. That means investors will be less willing to own bonds, and the resulting lower price equates to a higher yield. In short, higher inflation leads to higher bond yields—and lower inflation to lower bond yields.

But the yield curve isn’t just a reflection of inflation. Short-term Treasury yields are largely controlled—some would say manipulated—by the Federal Reserve. It achieves this by changing the federal funds rate—the interest rate one bank charges another for borrowing funds overnight. It’s no coincidence that the federal funds rate currently stands at 2¼% to 2½%, which is where short-term Treasury yields currently hover.

Meanwhile, intermediate and long-term Treasury yields are normally driven by market forces. How so? Bonds, like stocks, are constantly traded. That means their prices fluctuate. And as bond prices fluctuate, so do their yields—but in the opposite direction.

You can think of the yield curve as a rope. The left side of the rope, where we have three-month yields, is tethered by the Fed. But the middle and right side of the rope is free to roam. It’s the collective wisdom of bond market participants that determines the position of the middle and right end of the rope.

Why does an inverted yield curve predict recession? Since bond yields are essentially a reflection of inflation, both now and in the future, what the yield curve tells us is what investors think about future inflation. If the market believes inflation will be stable or higher in the future, this will translate into higher yields for longer-term bonds. The yield curve will slope upwards, with yields increasing for those bonds with a longer time until they mature. This is the normal situation.

If the market instead believes inflation will be lower in the future than it is today, this will be reflected in lower yields for longer-term bonds. The yield curve will slope upward less steeply—and it might slope downward. Voila, an inverted yield curve. What would cause the bond market to believe the inflation rate will fall? The answer: a slowing economy, including the possibility of recession. That slowing economy would reduce demand for goods and services, causing inflation to subside.

Five years ago, the difference between two-year and 10-year Treasury yields was 2.4 percentage points. Today, it’s just 0.2. We don’t yet have an inverted yield curve, but we’re awfully close. Does that mean a recession is in the offing? Only time will tell. But if you feel you’re taking too much risk with your portfolio—or there’s a danger you’ll lose your job if economic growth slows—think of it this way: You’ve been warned.

John Lim is a physician who is working on a finance book geared toward children. His previous articles were Grab the RoadmapBearing Gifts and Lay Down the Law. Follow John on Twitter @JohnTLim.

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