Yield curve inversion: A warning indicator for economic and market threats

By definition, a yield curve is the relationship between interest rates and maturity (of bonds issued by the same issuer and or similar/comparable bond issuers) at any given point in time. The yield curve is plotted by putting interest rate yields on the vertical axis and the maturity of the fixed-income asset on the horizontal axis. The overwhelming majority of the time, long-term interest rates are higher than short-term interest rates.

Investors take greater price and inflation risk with long-term bonds than short-term investments, and they almost always demand extra yield in compensation for that extra risk.

So what happens when short-term interest rates are higher than long-term interest rates? When this occurs, one sees an inversion in the yield curve.

When does this usually occur? Every recession since 1975 - including the financial crisis of 2008 - has been preceded by an inverted yield curve.

At the moment, we are experiencing the Federal Reserve’s increasing interest rate cycle. Even though there isn’t a precise relationship between the Fed’s rate and Treasury yields, the Fed’s actions have a direct impact on short-term rates rather than long-term rates.

This has been seen in fact this year. The three interest rate hikes done in 2018 and the way markets have been behaving have created an inversion in the yield curve. The fourth interest hike has just been announced by the Fed when it lifted the interest rate it pays on bank reserves deposited at the central bank by just 20 basis points, instead of the usual 25 basis points that would match the quarter-point increase for the fed funds target range.

Fundamentals and causation

As a starting point, yield curve inversions generally occur when the Federal Reserve has been boosting interest rates. The interest rates that the Federal Reserve raises are short term thus this tends to push the short term up relative to the long term, which is exactly what has been happening.

The reason the Fed is increasing rates is to slow down the economy. Now, if high economic growth is expected into the indefinite future, then the main danger for bond investors is inflation, and long-term bond yields should be rising relative to short-term yields.

However, if lower economic growth is expected, then less of a premium is required to compensate for inflationary expectations, and long-term yields should be falling relative to short-term yields.

So, the net effect of the Fed's increasing interest rates to slow down economic growth is to simultaneously increase short-term rates while reducing long-term yields relative to short-term yields. This first produces flattening, and then sometimes - but not always - there is an eventual inverted yield curve.

This exact pattern was part of the last three inversions and recessions - and it is well under way right now.

Signal that a change in cycle is coming

The best way to use a potential inversion in the yield curve is not as a dependable sign that a financial Armageddon is imminent, but rather, as a fundamentally based indicator that an actionable change in the cycle will soon be upon us.

The basis for the yield curve inverting is the combination of cyclical Federal Reserve actions, and the institutional investors using their money when they believe that a change in the cycle will indeed be occurring in the near future. In the endless cycle of recessions and expansions, they are changing how they value short versus long-term interest rates because of what they believe to be the oncoming cyclical change.

At this point in time, Powell is aiming to strike a careful balance, expressing a still- positive view on the US economy without transmitting a policy outlook that investors might view as too aggressive for an economy that appears somewhat more fragile than just a few months ago.

Disclaimer:

This article was issued by Maria Fenech, Investment Manager Support Officer at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.