Yield Curve For Dummies
You’ve heard the commotion. You’ve seen it plastered across your Twitter feed and cannot avoid it on CNBC. The yield curve. “But what about the yeeeee-ald curve? What are we going to do about the yeeee-ald curve! It’s flattening!” And you haven’t the faintest clue of what it means or why you should care at all, but somewhere deep in your stomach, perhaps maybe a touch slightly closer to your spleen, you wonder what you’re missing. Well, this post is for you.
If there was a cage match, battle royale of economic indicators, the yield curve would stand tall at the end, towering over a landscape littered by the smoking charred carcasses of its competitors. It is, bar none, the single best predictor of economic activity and equity performance in the intermediate term. Inversions of the curve nearly tautologically imply an impending recession and are associated with very poor market returns. It is the veritable deity of my school of economic thought: all knowing, all seeing, and all powerful.
What is The Yield Curve?
Probably the most appropriately named phenomenon in all of finance, the yield curve is simply a curve depicting yields at different maturities. If you’ve ever bought a CD (the financial one, not the music recording one) from a bank, you’re given a choice of time when you buy one. The longer the term, the higher the rate they pay. That’s it. Yield curve = yields for bonds of different durations.
In the financial world, the yield curve usually references US Treasury debt instruments. To finance its ever growing budget deficits, the Treasury issues debt routinely with variable due dates. As with CDs, the buyer can buy expirations best fitting their current need, from extremely short term, 1 month obligations all the way to 30 years.
Under normal circumstances, higher rates require longer durations of investment and the curve has an upward sloping shape (Good). From time to time, however, a phenomenon known as a ‘yield curve inversion’ takes place, where short term duration bonds pay higher yields than the longer term ones (Bad):
How Does It Move?
The dynamics of the yield curve are very important because they signal two inherently different activities in one relationship. These two different actors are 1) the Federal Reserve and 2) market expectations of inflation.
The Federal Reserve plays in the extremely short term part of the yield curve and conducts monetary policy much like the control rods in a nuclear reactor. If the economy heats up, it raises interest rates to make borrowing more expensive so that a hot economy does not turn into a meltdown. As the economy slows, it does the opposite to provide more liquidity and encourage investment/spending. The conduct of monetary policy has dramatically reduced the frequency and severity of recessions, but come at the cost of pervasive positive (albeit modest) inflation.
When you hear all the talking heads blathering on about Fed meetings, Fed minutes, policy stances, telegraphing, and any other of a million adjectives ever since Fed meetings became the most boring, predictable things ever (looking at you here, ex-Chairman Yellen), they are talking about the “Fed Funds Rate” which is an overnight rate and the normal conduit of interest rate policy for the nation. Since the rate only changes when the Fed announces policy changes, it moves in very large, step change type intervals. As ever, markets are incredibly efficient at predicting these policy changes, as seen by the 1-year Treasury’s prescient abilities leading the funds rate increases handily:
At the other end of the spectrum, longer term rates (10+ years) are controlled by investor sentiment about inflation and economic strength. In general, the thought process is stronger economic expectations leads to inflation which leads to higher rates. Weaker growth implies less inflation and lower rates. The ten and thirty year maturities are the most popular longer duration Treasury notes, with both frequently reported on CNBC and Bloomberg. My own preference is towards the ten year rate as a key economic indicator. A rapidly falling ten year rate generally corresponds to some amount of financial stress SOMEWHERE in the world. If you check bond rates and the 10 year is off 20 basis points in one day, I personally guarantee you some major cataclysm is under way and your stocks are most likely down seven to ten percent. Most obviously, this is seen in the 2008 meltdown:
While there is SOME relationship between short-term and long-term rates, they are like politicians answering to similar but different constituencies: the short rate answers to immediate impacts of the economy while the long rate looks at economic strength and whether or not the Fed is doing a decent job of managing long term inflation. The two rates can be visualized like a huge, scary dog on a very long leash. The Fed controls the short term rate by yanking it in the direction it wants to go and it has some control, but at the other end is something with a mind and power of its own (the long term yield). Both therefore have to respond to each other and constantly fluctuate. The best site to view current bond rates in real time is at CNBC.
The Yield Curve Spread
Since the two rates give fundamentally different information, the spread between the two is perhaps the most famous spread in all of modern finance. Indeed, I have long considered creating a shrine to the Yield Curve Spread next to my shoes in my closet and engaging in ritualistic worship on the second Thursday after Kwanzaa. It really is that powerful.
A “Yield Curve Spread” is simply the difference in the rates of 2 different maturities. My personal favorite (and the most standard) is the 10-year/2-year spread. The basis for this is the 10-year gives material information about inflation (as discussed above) while the 2-year gives real-time views on expectations about short-term interest rate policy. As mentioned above, the Fed Funds rate itself usually changes quarterly and in 0.25% increments. The 2-year, conversely, is heavily influenced by expectations of the Funds rate and leads the 1-year and shorter maturities.
When long term rates go UNDER short term rates, then the market is suggesting long term economic inflation will be subdued and economic growth quite poor. This generally happens at the end of a Fed hiking cycle, where rates increase enough that credit is too expensive to sustain further economic growth. Investors favor longer term security over a short-term sugar high, pushing long-term yields under near term yields. Plotting the 10-year/2-year spread, an amazing relationship becomes clear: when the spread goes negative, a recession is between 1 year and 3 years away:
The Yield Curve Predicts Recessions
This is no disingenuous chart-spin but rather statistically provable as written and describe on this blog. Over 70% of the year-on-year change in economic GDP is solely explained by time, a yield curve inversion, and the unemployment rate. This is an amazingly powerful result from an amazingly unsophisticated model! An inverted yield curve corresponds to roughly a 4% contraction in economic output (e.g. a pretty severe recession!):
The Cleveland Branch of the Federal Reserve provides their own analysis based purely on only the yield curve, and estimate recession probabilities based on this. At present, the Cleveland Fed expects a 17% chance a recession will unfold over the course of the next year:
Cleveland Fed Recession Probabilities
|Cleveland Fed Data||September||August||July|
|3-month Treasury bill rate (percent)||2.17||2.08||2.00|
|10-year Treasury bond rate (percent)||3.05||2.83||2.86|
|Yield curve slope (basis points)||88||75||86|
|Prediction for GDP growth (percent)||1.6||1.6||1.6|
|Probability of recession in 1 year (percent)||16.5||18.8||16.9|
An inverted yield curve nearly always means a recession is soon to follow, but why? The actual mechanism is unclear, with some (including the St Louis Fed) believing it is merely a signaling mechanism of unhealthy market conditions. I generally tend to believe this school of thought. Others believe that the mismatch in yields actually works to dry up corporate longterm lending.
The actual timing of a recession is impossible to predict, as recessions are inherently dynamic outcomes to changing market conditions. Feedback loops move in and out of the markets, forcing equity valuations, capital investments, interest rates, and labor decisions all to interact with and to each other in real-time. Hence I do not believe a rule can be determined but instead the yield curve should be viewed like the beginnings of an avalanche. When the snowfall is high (yield curve is inverted) things which might normally be fine and dandy all of a sudden have a huge risk of snowballing and bringing down the mountain. This might be an equity market meltdown, a bank failure, or some other fairly mundane thing.
The Yield Curve Predicts Equity Returns
All of the above no doubt mental pornography to an economic theorist, but why it matters to the average investor is this. Most of the FIRE blogs or Bogleheads or whatever else will tell you that what matters is ‘time in the market, not timing the market’, ‘you can’t predict returns’, or any other trite cliche nonsense bullshit that absolves you from owning the guilt from making crappy investment decisions. They are somewhat right in that trying to time the market month to month or year to year IS stupid and pointless. But your longterm return? To believe “time in the market” is what matters means you think this graph is nothing but noise:
The reality is your intermediate to long-term returns depend on 2 things: valuation and yield curve. The following graph plots starting valuation against subsequent 10-year equity return. Still believe ‘time in the market’ matters more than starting valuation? Those shapes look eerily similar…
But what about the yield curve? The following is a plot of the spread on the 10-year to 2-year Treasury against subsequent 3 year equity performance. Note the weaker performance at lower levels of the spread (particularly at negative levels);
This realization is no coincidence; in fact it is statistically relevant information that can be used to project equity returns. In fact, this realization is the underpinning fact of one of the most insightful posts I’ve ever written. Punchline: if the yield curve inverts, 3 year returns on equities are abysmal.
Where Is The Spread Now?
The Fed began hiking rates in December 2015, and despite the rather worrisome and troubling rantings of Donald Trump against the Fed, appear poised to continue hiking into 2019. The 10 year to 2 year spread is currently (as of October 20th, 2018) sitting at 0.29 basis points, a fairly severe retracement from its levels earlier in the year. Historically, this cycle of tightening from initial Fed rate hike to ultimate yield curve inversion is actually rather lengthy:
Is It Different This Time?
Most likely not. Oh, sure, you’ll read the ever present speculation that it is. Fortunately, Google is the most amazing thing ever and its very easy to see what people were saying the last time the yield curve inverted back in 1999-00 and in 2006.
Here’s a walk down the yield curves of yore:
- January 2000 – The Yield Curve Has No Predictive Power Whatsoever – If by ‘no predictive power’ they meant ‘is signaling a 13 year zero nominal return period for stocks’, they nailed it!
- January 2006 – Don’t sweat the yield curve, no one knows what it means! – My favorite here is “there aren’t any real excesses in the economy at the current time, and you usually think of recession as a tonic to the economy, to undo excess.” Great call, Wharton. You win the ‘Whoopsie-Daisy We Blew The Macro Call’ award for the Great Financial Crisis.
- January 2006 – 14 reasons why the yield curve isn’t the end of the world – A strong stock market also dilutes the inverted yield curve’s correlative strength. “Normally you see stocks falling along with yield curves inverting,” says Bill Schneider, managing director of DiMeo, Schneider, and Associates, LLC, who recommends investors stay with their current asset allocation. “You wouldn’t see markets reaching four-and-a-half-year highs.” How’d that work out for you?
What’s The “So What”?
The yield curve gives statistically important information about the direction of the economy and the equity markets. With market valuations at late 90s tech-boom type levels, the probability of a protracted period of very poor equity returns is extremely high. My own view is that it is possible to manage risk around the business cycle by lowering stock allocation in the final years of an economic expansion. My belief is this time is coming close and will be heralded by the inversion of the yield curve. Accordingly I continue to monitor it near-obsessively and will report on its downward trajectory.
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