The yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity. A yield curve is almost always upward sloping, a sign that the economy is functioning properly.
To best understand the yield curve, put yourself in the shoes of the lender, the borrower, and the investor. Each entity is rational and looking to do what’s best for their bottom line.
Due to inflation, the value of a dollar tomorrow is worth less than the value of a dollar today. Therefore, in order to profitably lend money, you must charge an interest rate. The longer the lending term, the higher the interest you should charge, hence the upward slope of the yield curve.
If the borrower has a poor credit score, runs an unstable business, has large job gaps in his resume, doesn’t read Financial Samurai, or doesn’t have many assets, then you need to charge an even higher rate to account for credit risk. If you can get a borrower to pay back an interest rate higher than your competition, you’re making superior economic returns.
If you are a bank, your main source of funding is from saving deposits. For the privilege of holding such deposits, you pay customers an interest rate and hope to lend out their deposits at a higher interest rate for a net interest margin gain. If the the yield curve is upward sloping, banks have an easier time achieving such profitability.
A rational borrower is incentivized to 1) borrow as much money, 2) for as long a period of time, 3) at the lowest interest rate possible to get rich. The more you borrow, the more you will likely invest. When the borrowing rate is equal to or below the inflation rate, a borrower is essentially getting a free loan.
The classic borrower example is the homebuyer. After putting down 20%, the buyer borrows the remaining 80%. The lower the interest rate, the more inclined the borrower is to take on more debt to buy a bigger, fancier house. When homebuyers want to stretch, they take out short-term adjustable rate mortgages (ARM) with lower interest rates versus 30-year fixed loans with higher rates. In a declining interest rate environment, taking out an ARM is an optimal move.
In addition to homebuyers, there are companies large and small, that borrow money to grow their respective businesses. If interest rates are lower at every duration, businesses will tend to borrow more, invest more, hire more, and consequently boost GDP growth.
The Investment part of the GDP equation: Y = Consumer Spending + Investment + Government Spending + Net Exports is vital.
Given the motivations of the borrower and the lender, the investor sees the yield curve as an economic indicator. The steeper the yield curve up to a point, the healthier the economy. The flatter the yield curve, the more cause for concern given the borrower’s doubt about the near future.
If there is a lack of demand for short-term bonds, pushing short-term yields higher, perhaps there is doubt about short-term economic growth. Similarly, if investor demand for long-term bonds keeps long-term yields low, this may mean investors don’t believe there are inflationary pressures because the economy isn’t viewed as trending stronger.
Short-term yields are also artificially pushed up by the Federal Reserve since the Fed Funds rate is the overnight lending rate – the shortest of the short. An investor needs to make a calculated guess as to how often and how aggressively the Federal Reserve will raise their Fed Funds rate and how the bond market will react to such moves.
The bond investor wins if inflation comes in below expectations. Inflation comes in below expectations when economic growth comes in below expectations. The stock investor wins if economic growth comes in above expectations, generating stronger corporate earnings growth, while interest rates remain at a level high enough to contain faster-than-expected inflation while not choking off investment growth.
Why A Flattening Yield Curve Is A Warning Sign
Take a look at the yield curve today versus the yield curve in 2017 and 2016. It’s clear the yield curve has flattened as short-term rates have risen faster than long-term rates.
If the Fed raises the Fed Fund rate by another 0.5% in the next 12 months the yield curve will be completely flat if not inverted by 2019 if long-term rates stay the same.
With a flat yield curve, you are disinclined to lend money over a long duration because the return is too low relative to the short-end. As a result, you tighten up lending standards and lend to only the most creditworthy people. You’d rather lend money for as short a time as possible because the interest rate you can receive is similar to the long-end. A shorter lending time horizon is also less risky than a longer time horizon.
Unfortunately, borrowers think exactly the opposite. Borrowers are less inclined to borrow capital short-term if the interest rate is very similar to long-term interest rates. They’d rather borrow at the same rate for a longer time period, but are often shut out due to more stringent lending standards.
If the yield curve inverts, i.e. when short-term interest rates are higher than long-term interest rates, the rational borrower slows or stops his borrowing. Only the most desperate (least creditworthy) borrower takes out a short-term loan at a higher interest rate (e.g. credit card and loan shark borrowers). This ultimately ends up hurting both the lender and the economy long-term due to ultimately higher default rates. A cascade of defaults by overstretched mortgage debtors is exactly what took the housing market down between 2007-2010.
There will eventually be an interest rate inflection point where the borrower not only stops borrowing, but starts saving more. With borrowers saving more, investment, by definition slows down. Multiply this action across millions of people throughout the country and the economy will turn south.
This Time Is NOT Different
In economics and finance, everything is rational long term. Investors take action to enrich themselves, while doing their best to avoid actions that will make them poor.
Take a look at the chart above. Within a couple years of the yield curve inverting (yellow), a recession ensued. Each time a recession ensued, the stock market took a dive.
The tricky part is not forecasting if a recession will happen once the yield curve inverts. The tricky part is forecasting when the recession will happen. If the Fed raises its Fed Funds rate by more than 50 basis points over the next 12 months, the yield curve will most likely be inverted as I’m of the belief long bond yields stay flat.
Therefore, the logical conclusion based on history is that a recession will arrive by 2020. Of course long bond yields can rise to prevent the inversion, but higher rates slow down economic growth. Therefore, either way, strong head winds are coming.
Yes, banks have taken measures to shore up their balance sheets and tighten lending standards since the last recession. But we cannot underestimate greed or the stubbornness of the Fed to over-tighten to prevent inflation from getting out of control. Everyone should be paying attention to a flattening yield curve and take precautionary measures to protect their wealth.
It’s much better to be a little too early protecting yourself than a little too late.
Readers, do you think this time time will be different? Will the long end of the yield curve begin to steepen as investors sell off safe assets for riskier assets? When do you think the Fed will stop tightening? When do you think the next recession will arrive?
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