Inversion of the Yield Curve
by Lavanya Batra
The collection of all Treasury bond yields are measured with an upward sloping curve, which represents bond yields and maturity rates, famously known as the Yield Curve. Generally, the curve is upward-sloping and is convex to the origin, i.e. it tells us that short term Treasury bonds have a lower yield than the long term Treasury
bonds. Conventionally, the short term bonds carry lower yields conveying that the investors’ money is at a lower risk. As the maturity increases, the yields rise which is considered as an advantage given to the investors for investing their money for a longer duration of time. The Curve has, historically, reflected the market’s sense of
interest rates and the economy, particularly inflation. Since inflation succeeds strong economic growth, a sharply upward-sloping yield curve means that investors have rosy expectations. The slope of the curve helps determine the future and current strength of the economy.
The Yield Curve inverts when the short term Treasury bonds have a higher yield than the long term Treasury bonds. An inverted curve indicates that investors expect lower interest rates in the longer run, and thus growth and inflation are anticipated in the near future. This drives down the yields, which fall when bond prices rise.
When investors expect longer-maturity bond yields to become even lower in the future, many would purchase longer maturity bonds to lock in yields before they decrease further. The higher demand for longer maturity bonds and the lack of demand for shorter-term securities leads to higher prices but lower yields on longer-maturity bonds, and lower prices but higher yields on shorter-term securities. This, further, inverts a down-sloped yield curve.
A case in point would be the American yield curve. “The interest rate on 10 year American Treasury bonds decreased and reached an all-time low. The value became less than the interest rate of 3 year American Treasury bonds which caused the American Yield Curve to invert”. Since lower interest rates generally mean slower economic growth, an inverted yield curve is often taken as a sign that the economy may soon stagnate.
There are a number of economic factors that impact Treasury yields, such as interest rates and the volatility of the market, inflation, and economic growth. In this case, the inversion of the American Yield Curve was majorly
caused due to the American-Chinese Trade War. Generally, the interest rate has an opposite relationship with price of the bond. As the interest rate increases, the price of the bond or the treasury tends to fall. Prices and yields move in opposite directions. When investors feel less interested in safe-haven Treasuries, they are more open to
riskier investments. This leads to a dip in the prices of the bonds, and the yields rise. When investors sense
volatility in the market, they seem to be more interested in buying Treasuries, thus pushing up the prices and
causing the yields to decline.
i = r + π
i = Nominal Interest Rate
r = Real Interest Rate
π = expected rate of inflation in the economy
On December 3, 2018, the Treasury yield curve inverted for the first time since the recession of 2008-09. Treasury yields are the total amount of money one earns by owning U.S. Treasury bills, notes, or bonds. Treasury yield prices are based on the demand and supply forces. If there is excess demand, the bond will go to the highest bidder at a price above the face value. This lowers the yield. Demand will rise when there is an economic crisis. This is because investors consider U.S. Treasuries to be the safest form of investment. As Treasury yields rise, so do the interest rates on consumer and business loans. Other bonds are riskier so they must have a higher return or yields to attract investors. As a result, interest rates on other bonds and loans increase as Treasury yields rise.
Over time, these higher rates increase the demand for Treasuries. Therefore, an increase in the interest rate of the long term treasuries leads to a rise in their demand and when longer maturities (treasuries) are in high demand, the yield curve can be inverted, which further lowers the interest rate to an extent that longer maturities with rates lower than shorter-term maturities are tangible.
To examine the same, it is important to highlight the antecedent conditions. The trade war between the U.S. and China worried the world since two of the world’s most advanced economies imposed tariffs on each other. The American economy imposed tariffs worth $125 billion on Chinese imports. Further, China responded by issuing
tariffs on an additional $75 billion worth of U.S. goods. Further, the United States imposed tariffs, bringing the total value of Chinese goods to half a trillion dollars, covering almost all Chinese imports. In total, the Trump administration has imposed three tariffs on a total of $250 billion in Chinese imports. It restricted companies from exporting American-made goods to 28 more Chinese companies and organizations which escalated the US-China Trade War. As the American GDP (real GDP) declined due to the Trade War, the economy also experienced a fall in the aggregate demand. This was concluded by a fall in the level of interest rates. Therefore, a drop in the level of interest rates forced the investors to lock down their investments at current interest rates as to prevent losses that further inverted the Yield Curve.
Primarily, the stocks and bonds are the worst hit by the inversion of the curve. A report released by the American government showed that manufacturing activity slowed to the lowest in almost 10 years. “The yield on the benchmark 10-year Treasury note rose for a second consecutive trading session, settling at 1.613%, compared with 1.577%. The yield on the 10-year note briefly fell below the yield on the two-year note, which ended at 1.606%”. Yields, which fall when bond prices increase, fell steeply after business activities in the private sector declined in both the service and manufacturing sectors. “The manufacturing index fell to 49.9 from 50.4, while the measure of services activity declined to 50.9 from 52.6 in August”. Stocks often continued to rise after the yield curve first inverts but on an average the moment the yield curve inverts, the market becomes highly volatile, resulting in a bad time to buy stocks.
PB ($) = 100 / (1 + r)
par value of the bond is
100$ PB is the bond price
r is the interest rate
The inversion of the yield curve also had an impact on the consumers. Homebuyers started financing their properties with adjustable-rate mortgages had to pay higher payments. This is due to the reason that when short term rates are higher than long term rates, payments on the mortgages tend to rise. When this occurs, fixed-rate
home loans may be more preferred than adjustable-rate loans. In both cases, consumers must dedicate a larger portion of their incomes toward servicing existing debt. This reduces disposable income and has a negative effect on the economy as a whole. A Yield Curve Inversion has the greatest impact on fixed-income investors. In normal circumstances, long-term investments have higher yields; because investors are risking their money for longer periods of time, they are rewarded higher payments. An inverted curve eliminates the risk premium for long-term investments, allowing investors to get better returns with short term investments. At the macroscopic level, the American economy was adversely affected. The tariffs hit U.S. consumers harder
than their Chinese counterparts: the United States sustained more economic losses than China related to the year-long trade war and the trade war caused American exporters to lose market share in China. Most of the U.S. deficit results from American enthusiasm for imported consumer products and automobiles. “In 2018, the United States imported $648 billion in drugs, televisions, clothing, and other household items. It only exported $206 billion of these consumer goods. That alone added $442 billion to the deficit. America imported $372 billion worth of automobiles and parts, while only exporting $159 billion. That added another $214 billion to the trade deficit”. In 2019, the American economy’s second-quarter GDP growth this year dropped to 2.0% from the first quarter’s 3.1%. The trade war was expected to shave off at least half a percentage point of U.S. GDP, and that much of a drag on the economy may tip it into the anticipated downturn. Moreover, increasing the volume of exports does not reduce trade deficits unless it is accompanied by a reduction in the country’s spending in terms of consumption and investment.
Another way of analyzing this scenario can be through the import-export analysis. As trade tariffs are imposed, the imports decrease. Therefore, the Net exports increase, which further leads to an increase in the demand for domestically produced goods. As a result, the price for domestic goods increases and gives way to inflation. An increase in inflation paves the way for a fall in the real interest rates. The major consequence that follows is the inversion of the yield curve. “Economists reckon the dead-weight loss arising from the existing tariffs on $200 billion in Chinese imports to be $620 per household, or about $80 billion, annually. This represents about 0.4 percent of U.S. GDP”. U.S. unemployment dropped to a half-century low in September and job growth continued at a modest pace: both signs that the economy is holding up despite a broader global slowdown. The jobless rate dropped to 3.5% in September from 3.7% in August, marking the lowest rate since December 1969. Theoretically, as the real interest decreases, the value of economic output (real GDP) reduces. Also, change in unemployment has an inverse relationship with the output growth (according to Okun’s Law).
Therefore,
a(Ut – Un) = %∆Y (Okun’s Law)
A reduction in economic output leads to an increase in unemployment. Job gains and historically low unemployment has helped buffer the U.S. economy against weaknesses in manufacturing at home and abroad, stoking concerns of a deepening slowdown.
Amidst the present scenario, the American Economy is undergoing a lot of pressure with a recession being expected by the economists and the Federal Bank. The Inversion of the Yield Curve is a situation where the short-term Treasuries earn higher yields than the long-term Treasuries. The markets hit an all-time low, which in turn, may affect the interest rates directly. A recession is foreseen which might further reduce the consumer price index, as well as create havoc in the investment market. Perhaps, one of the measures that can be taken to control the situation can be the United States’ reduction of its debt by letting the value of the dollar decline. When foreign governments demand repayment of the face value of the bonds, it will be worth less in their own currency if the dollar's value is lower.