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What Does an Inverted Yield Curve Mean?

Normally, fixed-income securities with a longer maturity date provide a risk premium for investors when compared to shorter-dated securities, reflecting the increased complexity inherent in their risk profiles (mainly interest rate risk and sometimes extension risk) over a longer investment horizon. This is best shown with a very familiar, upwardly sloping yield curve (Figure 1). Here, the swap curve increases as the investment horizon (the tenor) increases (from close to the 1.50% cash rate to 3.03% at the 15-year point).

Figure 1. Australian swap curve at the beginning of 2018

Source: BondAdviser

Most of the time and while expecting economic expansion, yield curves are generally as shown above. However, in some occasions (especially pre-recession), the yield curve can invert, indicating that the return offered by shorter-dated securities exceed longer-term securities’ offerings. Although forecasted interest rates are key in forming a benchmark level for the yield curve, investors’ preferences can also influence it and there are multiple factors which could lead to investors favouring longer-term investment options over short-term ones. These can include concerns over the reinvestment and roll of short-term securities, fear of capital losses as well as pessimism over the economic outlook.

Very interestingly, the financial market is often a portend of recessions and most recently maintained its track record with the inverted yield curve from 2006 to 2007. This quite accurately predicted the occurrence of a decline but perhaps not quite the severity which was the Global Financial Crisis (GFC). Figure 2 below shows the US Treasury yield curve in mid-2006 when it was at its most inverted (in a normal environment) where the 6-month rate was far greater than longer tenor rates. More specifically, the US Treasury yield curve started its first inversion (pre GFC) in December 2005 where the Fed raised the official Fed Funds rate to 4.25% (in an attempt to cool down housing markets), pushing the two-yield yield to 4.40% and which then exceeded the 7-year rate of 4.39%. The yield curve remained inverted until June 2007 when the regulator began reacting to declining indicators and cut short-term rates. By then it was of course too late to avoid the looming crisis even after multiple large cuts. Similarly, the Treasury yield curve inverted a few months before the recessions of 1981, 1991 and 2000.

Figure 2. Yield Curve Turning Inverted pre-GFC (17 July 2006)

Source: Bloomberg, BondAdviser

Due to this ‘forecasting’ ability, inversion is perceived as a powerful signal of recessions which has somewhat panicked the credit markets recently as the US yield curve continues its overall flattening trend (evidenced by the spread of 10-year rate over 2-year rate dropping to the narrowest in a decade (0.40%) on 18 April 2018), leaving investors with fears over the possibility of an actual inverted yield curve and what that could mean given that there is likely to be another few rate hikes by the end of this year.

Figure 3. The Current US Yield Curve (18 April 2018)

Source: Bloomberg, BondAdviser

Despite the increased fear over the potential inversion that might lead to another recession, the currently flattening US yield curve may actually be the mixed product of investors pricing in the multiple short-term rate hikes, improving economic conditions as well as a delayed response of long-dated investments (yields staying low) to improving fundamentals.  Long-dated securities, which are not as sensitive to monetary policy as short-dated ones could simply be taking a longer time to price in long-term rate rises or might be signalling long-term disbelief in a strongly strengthening economy.

We are still of the view that although total debt in the system is very large, it is manageable with moderate rate rises.  Credit fundamentals remain supportive also and there is little current evidence of significant deteriorations.  In summary an inverted yield curve, if one arrives in the near-term, may correct itself without a recession following.