August 15, 2019

If you were anywhere near financial news yesterday, you likely heard the term yield curve inversion more than a few times and observed a sharp equity sell-off.  We thought it was worth explaining what that term actually means – and why it may matter for investors

What are bonds again?

The global bond market represents trillions of dollars.  Bonds are financial instruments that companies and governments use to borrow money.  Every bond represents a promise to repay, plus a stated rate of interest for use of the funds over time (referred to as a yield or interest rate).

Wait, how is this different than a stock?

Stocks do not include any promise of repayment.  Instead, stocks represent a share of ownership in a business.  As an owner, you receive your pro rata share of the company’s earnings and growth over time

Got it.  Back to bonds – how are bonds priced?

Again, bonds are a promise to repay issued by a company or government.  Bonds tell a story about the underlying issuer as it’s important to know how likely they are to repay you.  A riskier issuer tends to have to pay more (ie: a higher yield) than a less risky issuer.  In addition, an issuer borrowing money for a longer period of time is willing to pay more (as investors want to be compensated for locking up money for longer and an issuer is willing to pay up to have access to those funds for a longer period)

What’s a yield curve?

The US government is one of the world’s largest bond issuers, with promises to repay at a variety of maturities (from 30 days all the way to 30 years).  The yield curve is the progression of US bond interest rates over the various maturities.  Said another way, if you plotted out the interest rates on each of the US debt maturities on a graph from shortest to longest in a “normal” state, the curve would steadily rise left to right.   Why?  Investors typically demand a higher return for locking up their funds for a longer period of time than a shorter one (and the US government is willing to pay more to have access to funds for a longer period of time).

So in steady state, the rate the US government will pay on a 10-year bond is higher than the rate they pay on a 2 year bond

What’s an inversion?

A yield curve inversion is when the graph we described above slopes downward, implying that shorter maturities pay more than longer maturities.

We saw this happen yesterday, when the rate on the US 2 year bond fell below that rate on the 10 year bond.  

How did this happen?

Bonds trade in the open market, just like stocks, and the pricing of them is driven by supply and demand.  If demand is higher than supply, the price goes up (and the yield thereby goes down as there is an inverse relationship between the two).  So, in recent weeks/months, there has been a higher demand for the 10 year bond than the 2 year bond.  This drives the price of the 10 year up (and the yield down). 

Why would investors favor the 10 year over the 2 year?  It seemingly indicates near-term uncertainty in the US’ promise to repay and implies more value in the 10 year promise versus the 2 year promise, as well as a desire to lock in that offered rate over 10 years

Why did stock markets react?

An inversion of the 2 year/10 year yield curve has been a predictor of recessions in the past, with the recession coming approximately 2 years after such an inversion.  Even though the inversion lasted only part of the trading day, it was enough to cause recession worries, trigger quant funds and algorithms, and lead to considerable equity selling

Is a recession a sure thing?

First, remember what a recession is.  It is NOT two quarters in a row of negative real gross domestic product (GDP) as is commonly believed. 

Rather,   a recession is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” 

There are many data points that have been examined in hindsight after recessions that are now believed to be valuable predictors.  The 2 year/10 year yield curve inversion is one of these metrics.  Recessions has always followed a yield curve inversions – but remember there are also cases where the yield curve has inverted and a recession has not followed.   .

Any good news?

There is always good news. First, a decline in rates is excellent news for borrowers. If you have any debt (like a mortgage), you may want to look into refinancing at these lower rates. Second, while there is a lot of uncertainty and volatility, there remains many positives in the US and globally. If you are an investor and not a trader, you have prepared for this and can endure these moves. Stay focused and don’t rush to react.