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Inverted Yield Curve Tutorial – What it is

By Louis Holding-Parsons on November 13, 2019

5 (100%) 1 vote[s]

Bankers spent a large amount of time and money trying to predict the future. The prize is to be on the right side of a trade, either for themselves or their clients. Many reports and analysis sent by bankers to clients add little value, yet every so often a report appears which requires a little pause. The Inverted yield curve is an example. As a rule, bond practitioners are more knowledgeable than their sales focused equity colleagues. When US government 10 year treasuries provide less yield than shorter duration US government 2 year treasuries, something is amiss. 

What is an inverted yield curve?

An inverted yield curve involves among other things, the relationship between risk and return If someone asked to borrow money off you, you would adjust the yield partly in relation to the length of time they are borrowing. I.e. the longer they are borrowing for, the higher yield you would charge. This is the normal relationship between risk and return. The higher the risk (in our example, the length of time) the higher the return you expect (an increased yield). Therefore what would you say, if the yield you were offered was lower for the longer dated investment than the shorter one? This would not feel right! Why would you expect a lower yield for a higher risk? The answer is interest rates and the expectation of where they will be.

The bond pricing mechanics

Most yield based instruments, more specifically bonds, are issued with a fixed yield. I.e. the coupon they pay out is the same each year. If someone pays 10% more than the next person for a bond, the total return they will get will be lower. The yield on a bond is set by a number of factors, primarily interest rate expectations and credit risk. If one of these factors moves during the lifespan of the bond, then the price of the bond will adjust to take into account this new reality. For example, if interest rates were to decrease, i.e. Central Bank Monetary Policies were accommodative, then a bond paying an above average yield would become more attractive and increase in value, unless investors preferred safety.

How did we get into this position?

An inverted yield curve signals problems aheadAn inverted yield curve is a sign of trouble ahead. Usually this means a recession. It does not predict when it will happen, but that it is likely it will. For the yield curve to invert itself, market actors, in this case central banks are taking actions which lead to this inversion. If a central bank is worried that growth is slowing, and that an economy is likely to contract, it will take steps to stop this, or reduce the impact. A “soft landing” reduces the impact of a recession, rather than a sudden drop in growth.

This controlled descent takes place due to central banks actions. The key area is money supply. If a central bank can increase the money supply by cutting interest rates, this encourages spending and investment. Western economies are dependent on their citizens consuming goods. If therefore, a central bank reduces rates, the yield curve adjusts.

Doors to manual: run for the exits

Protecting yourself from the reasons behind an inverted yield curve may bee needed!This adjustment happens once again due to the actions of market participants. If portfolio managers read that central banks believe there is stormy economic weather ahead, they too will take their own action. This involves a “flight to quality“, namely selling higher risk equities and buying lower risk bonds. The US 10 year treasury bond is considered one of the safest. As a herd of investors buy 10 year US treasuries, their price goes up (and due to the inverse relationship between bonds and yields) their yield goes down.

As this buying is sustained, the 10 year yield is pushed below the 2 year yield. leading to the 10 year yield curve arching downwards rather than upwards. According to conventional investing, you should be rewarded with a higher yield when taking more risk. Yet here, the riskier 10 year treasury is yielding less than the 2 year treasury. This is an inversion.

The high and mighty can get it wrong…

Some refusals to face up to what an inverted yield curve represents have led to some slip ups!It is possible to make money from an inverted yield curve but it is not for the faint hearted. As an inverted yield curve is predicting a cut in interest rates, any disappointment usually leads to volatility which you can take advantage of.  And rest assured even the high and mighty have got it wrong… Although the UK yields are not inverted, the Bank of England is having to eat some humble pie at the moment.

The Bank has been guiding for an interest rate increase for some time. Yet recently it had to backtrack, when multiple members of the committee voted to cut rates! This has led to the Governor being compared to an unreliable boyfriend! Who says Forex news isn’t as exciting as a TOWIE episode? After all, yield curves can make a fool of the most knowledgeable!

Conclusion

The increased Geopolitical risk occurring today, such the US-China trade war, Brexit and associated global slow down has spurred central banks into action. This has led to the inversion of the yield curve as investors seek safety. The problem is that repeated cuts to interest rates has lead to Negative Interest rates in some parts of the world, which is frankly helpful to no-one. Too much money chasing too few assets leads to asset bubbles, which will have to be faced up at some stage.

In turn this leads to a situation where investors are preferring safer assets. This choice is not only because of the cuts in interest rates, but because of the dangers which the current interest rate cutting cycle and quantative easing has created. An inverted yield curve this time round, may just be the sign that the game is up. To get out of it, we will need policy (government) response as well as central bank help.

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Louis Holding-Parsons

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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Louis Holding-Parsons

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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