The yield curve prices risk for all risky assets, and you wouldn’t purchase an asset without factoring in its price would you? Of course not, you’re much smarter than that.
Curves (usually) don’t lie: The ups and downs of yield curves
Because we can’t all be psychics with shops on a Jersey Shore boardwalk, investing is all about predicting the future with imperfect information.
Still, there are a few reliable harbingers of future economic conditions. One of them is the yield curve.
What does the yield curve tell us about recessions?
So what is this yield curve that everyone touts as the crystal ball of the economy? A yield curve is essentially a line that plots Treasury bond yields at different maturities.
Since the yield curve reacts to bond supply and demand conditions, yield levels at each maturity can tell you much about what investors think about where they’re putting their money.
Investors and bankers can say whatever they want on CNBC, but where they’re investing never lies.
The four types of yield curves
There are four types of yield curves: normal (or upward sloping), steep, flat, and inverted (downward sloping). In general, the curve’s shape informs investors’ future rate expectations.
Normal (upward sloping) yield curve
A “normal” yield curve is one where longer-dated maturity bonds have higher yields than shorter-dated maturity bonds. So when you look at the yield curve, it appears upward-sloping.
For example, would you be more comfortable with someone borrowing money from you and promising to back you the next day or pay you back in 30 years? Unless you’re the most trustworthy person on Earth, you would probably be more comfortable with someone paying you back the next day. If they were to pay you back later, you would need more significant compensation in the form of higher interest.
Steep yield curve
A steep yield curve has significantly higher yields on long-dated maturity bonds than on short-dated maturity bonds. The longer-dated maturity bonds do not flatten out as they would in a normal yield curve.
A steepening yield curve generally implies a growing economy since rates are expected to rise in response to a healthy economy with higher inflation.
Flat yield curve
A flat yield curve is one where the yields across all bonds of different maturities are around the same level. Two factors can cause a flat yield curve:
- The shorter end of the curve rising, usually in response to an expectation for the central bank to increase targeted policy rates.
- The longer end of the curve falling, usually as uncertainty and fears of higher inflation and slowing economic growth set in.
Inverted yield curve
An inverted yield curve is marked by shorter-dated maturity bonds having higher yields than longer-dated maturity bonds. Inverted yield curves appear to be downward-sloping.
An inverted yield curve is known to be a potential recession signal since it shows that investors expect yields on longer-maturity bonds to decrease, which occurs during an economic downturn.
Yield curve theories
It’s all fun and games to observe the yield curve and use it to predict economic conditions. But what influences yields? A heated debate roars about that roars:
- Pure expectations theory: The difference in rates comes down to differences in expectations of interest rates and inflation in the short- and long-term. The theory is anchored in the three components of the Treasury yield curve: real rates, inflation premium, and interest rate risk premium. Essentially the theory says that investor expectations for real rates, inflation, and interest rate risk premiums will determine the yield curve positioning.
- Liquidity theory: This theory says that all investors prefer short-term maturities since longer-term maturities carry a higher interest rate risk. However, this theory does not explain flat and inverted yield curves.
- Market segmentation theory: This theory says that while the yield curve is largely based on supply and demand, investors’ constraints can also have an effect. For example, some pension funds invest in bonds with durations that match their liabilities. Therefore, the yield curve is not purely based on investors seeking the best yield.
- Preferred habitat theory: Similar to market segmentation theory, this one says that the yield curve is not purely based on investors seeking the best yield; instead, they may have their own personal preferences. For example, an investor may prefer short-term bonds and will only invest in longer-term bonds when yields are especially juicy.
TLDR: In reality, the truth probably lies somewhere in the middle of all four of these theories.
How accurate is the yield curve at predicting economic downturns?
Listen, I’m not saying that you should purchase triple-leveraged bear ETFs when the yield curve inverts and triple-leveraged bull ETFs when the curve steepens. However, the yield curve has a fairly strong track record of anticipating short to mid-term changes in economic conditions.
What I am saying is this: Do not ignore the yield curve when making investment decisions, and use it as a part of a full framework when setting your market expectations.
In 2022, the yield curve inverted (between the 2-year and 10-year Treasurys) for the first time on April 1, before normalizing shortly after on April 5, and inverted again on July 6. Of course, you can’t say that we’re guaranteed to be heading for a recession just because the yield curve inverted. However, when you factor in high inflation, supply chain challenges, tight labor markets, lingering Covid-19 impacts, Russia’s invasion of Ukraine, and increasing uncertainty amongst consumers and investors, you can conclude from all these factors that there is a higher probability of a recession.
Always start at the yield curve
Whenever you’re evaluating the financial markets and the economy, you should always start by looking at the yield curve. The yield curve prices risk for all risky assets, and you wouldn’t purchase an asset without looking at its price would you? Of course not: We know you’re much smarter than that.
