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On April 1 2022, the yield of the U.S. 10-year Treasury note dropped below that of the 2-year yield. This phenomenon, dubbed ominously as a "yield-curve inversion", is said to be a harbinger of recession as it has historically preceded every recession since the 1978.
The chart below shows the U.S. Treasury yield curve inverting in August 2006, about a year before the Great Recession in the U.S in 2008. Also note the overall shift in the yield curve downwards from 2006 to 2008, indicating an economic contraction in 2008.
In this article, we explain what is a yield curve, what brings about the changes in a yield curve i.e. steepening, inversion, parallel shifts, and what these changes indicate about the economy.
What is a yield curve?
A yield curve is a plot of interest rates of bonds with the same credit quality, against different maturity dates, at a set point in time.
The interest rate of a bond is the percentage return demanded by buyers of the bond. When an investor buys a bond, the investor is essentially lending money to the bond issuer. In return, the issuer will return the principal to the investor at maturity, with an interest amount on the loan.
A bond investor is exposed to various risks, namely inflation, credit and liquidity risk. The interest on the loan compensates the investor for these risks. Bond investors use the yield curve to gauge the expected return if the investor were to invest in a short, medium or long term bond on a particular day.
The yield curve is not static. Depending on the level of each risk component, the interest rates of bonds changes daily, giving rise to yield curves with different slopes and shapes. These changes in the yield curve, in particular the U.S. Treasury yield curve is used as an indicator of financial market conditions.
The U.S. Treasury Yield Curve
While yield curves can be plotted for different types of bonds, the U.S. Treasury yield curve is widely used as an indicator of global economic conditions, due to the central role of the dollar in the international financial system. Moreover, U.S. Treasury securities are considered to be free of default risk as they are backed by the U.S. government. Hence, the yield on U.S. treasuries represents the real interest rate (cost of borrowing) and the premium for expected inflation (compensation for the risk of deterioration of the value of the income from investing in these securities).
The U.S. Treasury yield curve tracks the yield of different U.S. securities with different maturities:
Maturity | U.S. Treasury Securities |
|---|---|
4, 8, 13, 26 and 52 weeks | Treasury Bills |
2, 3, 5, 7 and 10 years | Treasury Notes |
20 and 30 years | Treasury Bonds |
Short-term interest rates are directly influenced by the Federal Fund Rate (and the market expectations for it), while long-term interest rates are more sensitive to supply and demand in the market, which is a function of inflation expectations, the Fed's open-market operations and large trading volumes from institutional investors. Hence, short- and long-term interest rates do not necessarily change by the same magnitude, causing changes in the shape and slope of the yield curve.
The different types of yield curves and its indications about the economy
Analysts look out for two main characteristics of the treasury yield curve, namely the shape (upward or downward slopping) and shifts (parallel or non parallel shifts).
1. Shape of the Yield Curve - Upward or Downward Sloping?
The slope of a yield curve shows the market's expectations of future interest rates. It also provides a brief snapshot of the difference in yield an investor can expect from holding a short- vs long-term bond.
Upward sloping yield curve
Under normal market conditions, the yield curve is upward sloping. This is because investors in longer-term maturity bonds are compensated for the risks and opportunity costs in having their money tied up in a bond that repays its principal later in the future.
Downward sloping yield curve (inverted yield curve)
When the market expects there to be a slow down in the economy or a recession in the future, the yields on longer-term bonds, i.e. bonds with maturity 10-years or longer, will drop towards shorter-term securities, i.e. two-year notes.
As the market expects an economic contraction in the future, bonds represent a less risky investment. The drop in longer-term yields is a result of an increase in demand for bonds with longer maturities, resulting in an increase in price and thus a decrease in yield.
2. Shifts in the Yield Curve - Parallel or Non-Parallel Shifts?
Shifts in the yield curve happen when there is unexpected inflation. (Recall that the interest rate of a treasury security is the sum of real interest rate and expected inflation).
When there is high, unexpected inflation, the Fed will try to curb demand by increasing the Federal Fund Rate, making borrowing money more costly. Thus, interest rates increase when there is high inflation, causing a shift upwards in the yield curve.
Parallel shifts
A parallel shift in the yield curve occurs when interest rates change by the same magnitude for each maturity. However, parallel shifts in the yield curve is uncommon. We will discuss non parallel shifts in the yield curve next.
Non-parallel shifts
As interest rates rise, the increase in short-term interest rates is usually higher than long-term interest rates. For instance, when the interest rates on a two-year note increases by 2%, the increase on a 10-year note may only increase by 1%.
This is because the market expects the increase in short-term interest rates to cause a future slow down in the economy. Hence, there is less need for an increase in long-term interest rates that is as aggressive as that of the increase in the short-term interest rates.
When there is a non-parallel shift in the yield curve, analysts look out for two characteristics in the new yield curve:
(1) Slope steepness
When short-term rates rise faster than long-term rates, the resulting yield curve is flatter (see chart above). This is a signal of a weaker economy in the future.
Conversely, when long-term rates rise faster than short term rates, the resulting yield curve is steeper. This phenomenon is sometimes referred to as an "increase in spread between short- and long- term interest rates". A steepening yield curve indicates a stronger economy in the future and rising inflation expectations.
(2) Yield curve curvature
The yield curve can increase in convexity or flatten depending on the rate at which short- and long- term interest rates rise compared to medium-term interest rates. When short- and long- term interest rates rise faster than medium-term interest rates, the resulting shape of the yield curve is known as a "positive butterfly" , whereas a "negative butterfly" is seen when medium-term interest rates rise faster than both short- and long-term interest rates.
The shape of the yield curve is often used by bond investors in deciding on their bond trading strategy. When the yield curve has the shape of "positive butterfly", a common strategy is to buy the body of the butterfly, i.e. long medium-term bonds, and sell the wings, i.e. short the short- and long- term bonds at the same time. The notion behind this trading strategy is that bond investors are expecting medium-term yields to continue dropping, which means an increase in medium-term bond prices in the future; while short- and long-term yields will continue rising, which means a decrease in prices.
Summary
The yield curve is a plot of the expected return on a bond across different maturities.
The yield on U.S. Treasury securities is a function of real interest rates and expected inflation. Given the central role of the US dollar in the economy, the U.S. Treasury yield curve is often used as an indicator of current and future market conditions. An upward sloping Treasury yield curve generally indicates that the financial markets expect higher future interest rates, signalling a growing economy; a downward sloping curve indicates expectations of lower rates in the future; signalling an economic slow down.
Short-, medium- and long-term rates also change at different magnitudes, changing the shape of the yield curve. A steepening yield curve, a result of long-term interest rates rising faster than short term interest rates is an indicator of a stronger economy in the future while a flattened yield curve, a result of short-term interest rates rising faster than long-term interest rates, is an indicator of a weaker economy in the future.
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