What is yield curve inversion?

What is yield curve inversion, and why its important

When it comes to trading and investments, an important thing to understand, that is often overlooked, is the yield curve.

The yield curve describes the relationship between interest rates and the length of time until a debt is repaid. In recent months, there has been a great deal of discussion about something called “yield curve inversion.” What does this mean for traders and investors? Let’s take a closer look. . . .

In this blog post we will explore:

• What are bonds
• What are bond yields
• What is the yield curve?
• What is yield curve inversion?
• Why is yield curve inversion important?
• What is currently happening with the yield curve (in Q1/Q2 2022)?
• Yield curve inversion takeaways

What are bonds?

Bonds are debt instruments that are issued by governments and corporations, so they are effectively a loan. The issuer of a bond agrees to make periodic payments of interest, called coupons, to the holders of the bond until the maturity date. At maturity, the issuer is obligated to repay the par value (or principal amount) of the bond to the holder.

In order for a bond to be traded in the secondary market, it must have a rating from one of the credit rating agencies. Bond prices and yields are impacted by a variety of factors including economic conditions, inflation expectations, and changes in interest rates.

What are bond yields?

Bond yields are an important metric to monitor for all market traders, and also for investors (bond yields represent the annual return that investors can expect from a particular bond). The higher the yield on a bond, the more attractive it is to investors. Yields can fluctuate based on several factors.

When you invest in a bond, you are lending money to the issuer of the bond for a certain length of time. In return, the issuer agrees to pay you back your principal plus interest. The amount of interest paid depends on a number of factors, including the maturity date and credit rating of the bond. One important factor that determines how much interest a bond pays is its yield. Yields are determined by many factors, but one key calculation is the present value of all future payments made on the bond.

The easiest way to calculate a bond yield is by dividing its coupon payment by the face value of the bond. This is the coupon rate.

Coupon Rate=Bond Face Value/ Annual Coupon Payment

For example, let’s say a bond has a face value of $10,000, which pays interest (or coupon) payments of $1000 per year. The simple math tells us that it has a coupon rate of 10% ($1000 / $1,0000 = 10%). But remember, a bond is often purchased in the secondary market for a price below its face value (which is termed, at a discount), or for a price above its face value (which is at a premium). This will then alter the yield the investor earns on the bond.

So, as bond prices fall in the secondary market, bond yields rise, and conversely, as bond prices rise (in the secondary market), bond yields fall.

What is the yield curve?

The yield curve is a graphical representation of the maturity of government bonds (but also corporate bonds), plotted against their yields at different maturity dates. It usually slopes upward, with shorter-term maturities offering lower yields than longer-term maturities.

The shape of the curve can provide valuable insights into investor sentiment and economic conditions.

There are three main shapes that it can take:

• Normal (upward-sloping)
• Inverted (downwards slope)
• Flat

An upward-sloping or normal yield curve shows yields on longer-term bonds higher than shorter-dated bonds and reflects an expectation of a longer-term healthy economy and anticipation of economic expansion. This is the most common type of yield curve as longer-maturity bonds usually have a higher yield to maturity than shorter-term bonds. But why is this the case?

The yield curve is usually upward-sloping because debt issued or trading in the secondary market with a longer time to maturity broadly speaking carries greater risk. This is because of several factors, the main two being:

• There is a greater probability of inflation, which erodes the value of the interest/ coupon payments that are being received.
• There is a greater likelihood of default, in the long run, meaning that the initial payment or principal is not repaid at all or not in full.

A downward-sloping or inverted yield curve is when longer-dated bonds have a lower yield than bonds with shorter maturity dates. This is non-normal and can have significant ramifications, which we will take a look at now.

What is yield curve inversion?

In general, when longer-dated bonds have a lower yield than shorter-dated bonds, the curve is said to be “inverted”, therefore the term, yield curve inversion. And this can be an important indicator of future economic conditions, as we will explore below. But an important point to note at this juncture, is where on the yield curve does the investigation take place?

As we have stated, the yield curve is a set of points that describe the yield at different maturities of bonds. So it is possible that different segments of the yield curve can invert, whilst other segments of the curve are still normal or upward sloping. For example, the 5yr-30yr sector may invert, that is 5yr bond yields move higher than 30yr bond yields. But the 2yr-10yr sector may still be normal, with 2yr bond yields below 10yr bond yields.

So, when we talk about the yield curve inverting, it’s important to understand if it’s the whole curve or part of the curve, and if so, what part of the curve it is we are referring to ( we’ll take a closer look at this later).

Why is yield curve inversion important?

When the yield curve inverts, this is typically interpreted as a sign that investors expect economic recession or deflation in the future. Simply put, the market is expecting lower interest rates in the future because it perceives that monetary policy will need to be looser to stimulate the economy.

When yield curve inversion occurs, it can cause a great deal of concern among market strategists, investors, traders, and Central Bankers, as the belief is that historically the inversion of the US yield curve has preceded every major recession in the United States since 1950.

To be clear, we are looking at the US Treasury curve inverting and its ability to predict future recessions, (This impacts global markets because the US bond market is the world’s largest bond market, and the US is the world’s largest economy)

However, when talking about yield curve inversion, it’s important to look at the actual details of what part of the US Treasury curve we are talking about, and ask ourselves did recession in the US always occur after, and when did the recession occur?

It’s important to note that when an inversion of the whole curve has been sustained over a sufficiently long period – at least one month, it has predicted all recessions of the past 50 years. BUT, in the past, some segments of the yield curve have inverted, and this has not always led to recession.

What is currently happening with the US Treasury yield curve (in Q1/Q2 2022)?

In late March 2022, the 5yr-30yr US Treasury curve inverted for the first time since 2006.  Since then, the much-watched 2yr-10yr sector of the same curve has very briefly inverted, even if only during intraday trading. But this is not enough to state that there is going to be a recession in the next 1-2 years.

In fact, Federal Reserve Chairman Jerome Powell addressed this very point on Monday 21st March in response to a question at the National Association for Business Economics. He said “Frankly,  there’s good research by staff in the Federal Reserve system that really says to look at the short — the first 18 months — of the yield curve,” This part of the curve, at the time of writing, as measured by the implied yield on three month T-bills in 18 months against three month T-bills is still steep.

However, some commentators and strategists do not believe that Jerome Powell has it correct, and this is not the most relevant part of the curve to be watched.

So, at the moment, the jury is still very much out and undecided on whether the warnings seen thus far from the US yield curve are in fact a forewarning of a recession later in 2022, or into 2023.

Yield curve inversion takeaways

• Bonds are financial market instruments of debt that are issued by both governments and corporations, effectively they are a loan.
• Bond yields are the annual return that investors can expect from any particular bond.
• The yield curve is a chart of the maturity of government bonds at different maturity dates, plotted versus their yields.
• A normal yield curve is upward sloping, so starts with low-interest rates for shorter maturity bonds, and then yields increase as you move through to higher maturity bonds.
• Yield curve inversion occurs when shorter-dated bonds have a higher yield than longer-dated bonds, the curve is described as “inverted”, it is downward sloping.
• An inverted yield curve is generally seen as a signal that the bond market expects an economic recession or deflation in the future (usually within 1-2 years).
• So far in Q1/Q2 2022, the US Treasury market has experienced yield curve inversion in various segments of the curve. But this is not a guarantee of a future recession. Maybe this time will be a different case, or maybe we are looking at the “wrong” part of the yield curve. The jury is still out as to whether the current yield curve warning signs will lead to a recession later in 2022, into 2023, or even out to 2024.