It’s been over a decade since the global financial crisis, and yet economies are still struggling with the aftermath. Last July, the International Monetary Fund published that global growth remained sluggish. The trade war tensions between China and the US have continued to escalate while uncertainty on Brexit continues to negatively impact UK and EU economies.
The yield curve is a main tool used for making economic predictions. This is mainly a graph that plots market remuneration rates, that is interest rates of bonds with equal credit quality but different maturity dates. The slope of the yield curve predicts any future yield changes and economic activity. The yield curve may be either upward sloping (normal), downward sloping (inverted) or flattening.
The market remuneration rates is what we refer to as the yield to maturity. This is the single interest rate which divides the present value of the bond’s payment to price. The yield to maturity is calculated as an average rate assuming that the bond is held until maturity and reinvestment of any coupon payments. It thus provides a standard annualised measure of return.
The shape of the yield curve is dependent on several factors including the rating of the bonds under consideration and economic conditions. It also depends on the maturity preferences of investors and borrower, as well as their expectations about future rates, inflation and economic prospects. So the yield curve represents the evolution of the yields over different maturities.
Under normal circumstances, the yield curve is upward sloping, as longer-dated bonds have a higher yield than short-dated ones. Since long-term bonds are exposed to a higher risk, their yields should be greater as well. The higher the maturity, the higher is the probability of unexpected negative events to occur which results into higher volatility. Investors need to be compensated for any additional risk, as stated by the liquidity preference theory. Hence, there is a liquidity premium for long-dated bonds since changes in interest rates will have a greater effect on their price, than on short-term bonds.
A steep upward curve suggests that investors expect inflation and interest rates to significantly rise in the future. The curve can be steep if an economy is pulling out of a recession. As a result, lenders tend to demand for higher yields, hence the steepening of the yield curve.
A very powerful indicator which investors should focus on is the difference between two-year and 10-year yields. A low yield spread indicates that investors expect less future growth. On the other hand, a high yield spread indicates investors’ confidence of a more vigorous economy. However, if the yield spread is too high, this might also be an indication of a possible danger for consumer inflation.
Since long-term bonds are exposed to a higher risk, their yields should be greater as well
If a bond’s yield is much higher than the rate it was initially issued at, this implies financial stress from the issuer’s end which might result into capital not being repaid back. Conversely, a negative yield reflects the challenges of central banks and the expectations of a low-yield environment. This is when investors are better off if they sell their bonds now at a sufficient premium than keeping them until maturity. While this creates a bonanza for borrowers, lenders and savers end up suffering.
When the yield curve is inverted, long-term yields fall below the short-term yields. Up to a few months ago, the US government was paying investors more if they invest for two years than for 10 years. This is considered as a ‘powerful economic omen’. This was an unpleasant period which triggered recession fears but has now reversed itself. The plunge was very severe, as the yield on the 10-year treasury note fell below the three-month bill and the two-year note. The Federal Reserve (Fed) reacted to this deviation by cutting rates, widening the spread back into the green last October. Historically, an inverted yield curve was an accurate prediction of an economic slump. The financial crisis which led to a recession was preceded by an inverted yield curve in December 2005. However, history does not always repeat itself. An inverted yield curve does not necessarily lead to a downturn in the market, it could indicate that the economy is only cooling off. This will depend on the length of the inversion and whether the lag was a significant one.
This was the case a few months ago in the US, whereby the yield curve started to flatten and finally moved back into a normal shape, resulting into some relief in the markets. Investors are expecting inflation to slow down and a more tepid economic growth.
In the US, the yield curve has flattened to its lowest level since the last recession, as the spread shrunk to circa 10 basis points. When the yield curve starts to flatten, both long-term and short-term bonds have similar yields. This can lower lenders’ willingness to lend, or demanding a higher time premium, which ends up slowing down the business cycle.
Some analysts argue that it is irrelevant if the yield curve returns to positive territory. If the yield curve is completely inverted at a certain point in time, then the damage is done and cannot be reverted. However, this time round, the Fed reacted immediately through three rate cuts which is seen as an effective way to safeguard economic expansion. In the last recession, the Fed started to lower short-term rates almost a year after the yield curve was inverted.
The yield curve holds predictive powers, but like most indicators, is not perfect. It is fair to conclude that an inverted yield curve does not herald imminent danger just as a normal one does not indicate the economy is in the clear.
This article was prepared by Lianne Zahra, B.Com (Hons) Banking & Finance, trader at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on 2122 4410 or e-mail email@example.com