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Back in October, the market was freaking out about surging U.S. bond yields.

And this week, U.S. bond yields are under the spotlight again since the market is worried about this “yield curve inversion” thingy.

What’s a yield curve inversion, you ask? And why all the hubbub about it? And what the heck is a yield curve in the first place? Well, all that and more will be discussed in today’s little primer.

What’s a yield curve?

If you were able to read up on our school’s lesson on How Bond Yields Affect Currency Movements, as well as my previous Primer On Government Bonds, then you already know that bond yield just refers to the return on investment from a bond and that rising bond yields ain’t really all that bad. In fact, rising bond yields are used as a gauge for economic growth.

But what’s a yield curve? Well, a yield curve just refers to the difference (i.e. the spread) in yields between bonds of the same quality but different maturity dates.

And for the purpose of today’s little primer, “bonds of the same quality” refer to U.S. government bonds.

As for the “different maturity dates,” did you know that the U.S. Department of the Treasury issues bonds in 12 maturities and classifies them into three?

  • Treasury Bills: 1-month, 2-month, 3-month, and 6-month
  • Treasury Notes: 1-year, 2-year, 3-year, 5-year, 7-year, and 10-year
  • Treasury Bonds: 20-year and 30-year

The only real difference is that Treasury Bills are sold at a discount and don’t pay interest before the maturity date (since interest is paid semi-annually).

And finally, the “difference in yields” refers to, well, the difference in yields.

And normally, longer-dated bonds have higher yields compared to short-term bonds. And as you can see in the overlay below, for example, 30-year bonds offer higher yields compared to 10-year bonds, 10-year bonds have higher yields than 5-year bonds, and so on and so forth.

Overlay of The Yield of Various U.S. Bonds
Overlay of The Yield of Various U.S. Bonds

And if you’re asking why, then you were probably sleeping when the concepts of Maturity Risk Premium, Time Value of Money, and Opportunity Costs were being discussed during your Economics class.

But if you genuinely don’t know or just forgot, then just ask yourself this:

If a rich uncle you never knew about suddenly appeared and made you choose between getting a $1,000 gift next month or getting a $1,000 gift next year, which would you choose?

You’d obviously want to get the $1,000 by next month, right? There are a lot of risk events over the course of a year after all, not to mention inflation. Also, if you get that $1,000 now you could invest it and probably have a bigger return.

But if the rich uncle changes his offer to a $1,000 gift next month or a $2,000 gift next year, then you would probably stop and think about getting that $2,000 gift next year instead.

Well, the same underlying principle is at work with regard to bond yields.

And normally, if you plot the yield of bonds of varying maturities, the yield curve would look something like this.

Normal Yield Curve
Normal Yield Curve

Again, notice that as the maturity period increase (moves to the right), the yield also increases (moves higher). Actual yield curves ain’t as pretty as that one, though.

What’s a yield curve inversion?

Now that you (hopefully) understand what a yield curve is and what a normal yield curve looks like, it’s time to discuss yield curve inversion.

And yield curve inversion just means that the yield of longer-term bonds goes below the yield of shorter-term bonds.

Do take note that yield curve inversion and an inverted yield curve are different concepts, to be more technical about it.

An inverted yield curve is the end result of a complete yield curve inversion, which is to say that the shortest-term bonds now offer the highest yields while the longer-dated bonds have the lowest yields.

Basically, we’re referring to a situation like the highlighted area below. Do take note that 3-month bonds (purple) have the highest yield in the highlighted area below, while the 30-year bonds (blue) offer the lowest yield.

And if you plot the yields of those bonds, then the yield curve would look something like this.

Inverted Yield Curve
Inverted Yield Curve

Why all the hubbub about yield curve inversion?

Well, according to a June 1996 study by the New York Fed (emphasis mine):

“The yield curve — specifically, the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill — is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead.”

The Cleveland Fed’s November 2018 report on Yield Curve and Predicted GDP Growth, meanwhile, had this to say (emphasis mine):

The slope of the yield curve — the difference between the yields on short- and long-term maturity bonds — has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last seven recessions. One of the recessions predicted by the yield curve was the most recent one.”

In short, a yield curve inversion signals that a potential recession may be coming in roughly a year’s time.

However, it’s worth pointing out that the Cleveland Fed also noted that:

“There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998.”

Did a yield curve inversion really happen?

Yes … there kinda was … technically speaking.

The yield of 5-year bonds moved below the yield of 2-year bonds on December 3, which is the first inversion in an over a decade and naturally made market players skittish.

Don’t get me wrong. That’s technically a yield curve inversion.

However, the yield curve inversion that the Fed is keeping an eye on and that has heralded the last seven recessions is the one between the “ten-year Treasury note and the three-month Treasury bill as the New York Fed puts it.

And as you see in the chart above, there’s still a lot of distance to cover before the yield of 3-month bonds (purple line) crosses over with the yield of 10-year bonds (green line).

Moreover, the chart below from the Cleveland Fed shows that the last seven recessions (shaded areas) only happened after the yield spread between 10-year and 3-month bonds turned negative by going below that there dark, horizontal line. But as you can also see, there are presently still some ways to go before the yield spread turns negative.

In summary, the yield curve inversion is used as a leading indicator for recessions. And the market got jittery because of the inversion between the yield of 5-year bonds and the yield of 2-year bonds, which is the first inversion in over 10 years.

However, the best leading indicator for a potential recession (even according to the Fed) is arguably the yield curve inversion of 3-month and 10-year U.S. bonds. And based on the last seven recession, a recession only occurs after the yield spread turned negative.

But at present, the yield of 3-month bonds has yet to cross over with the yield of 10-year bonds.

And I just want to highlight once more that the Cleveland Fed also noted that:

“There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998.”

The correlation is therefore not absolute, which is why I stressed that a yield curve inversion of 3-month and 10-year U.S. bonds is only a leading indicator for a potential recession.

They are coming closer together, though, and the yield spread has been steadily grinding towards the zero marks (and possibly below it), which is a cause for concern.

And it certainly doesn’t help that Fed Chair Powell, Fed Vice Chair Clarida, and the latest FOMC minutes all signal that the Fed is shifting to a more neutral monetary policy stance.

And of course, we have to acknowledge that the market is driven partly by emotions and a negative spread between 3-month  and 10-year bonds and a subsequent recession could become a self-fulfilling prophecy.

That does mean potentially higher volatility, though, so…