The significance of the inverted yield curve
Global capital markets have been roiling and boiling in roller-coaster activity for months, as various country twitterheads-in-charge jockey for trade concessions with various tactics, including tariffs and economic sanctions.
Of course these disputes won’t economically affect them as it certainly appears they are comfortably above that kind of personal financial instability.
However, ordinary people with pensions, savings, and investment accounts are left watching the value of their hard-earned money assets vacillating wildly from positive to negative and back again.
There are other hand-wringing situations, such as corporate CEOs and company budgeters trying to normalise their forward planning; market strategists endeavouring to provide reasonable technical analysis in the face of abrupt outlier manoeuvrers; the 24-hour a day institutional investment traders attempting to anticipate the extreme volatile swings; and numerous other capital market segment participants.
Global investment market volatility is influenced by many factors.
If you watch, read, or listen to any investment market media, trade parlance such as risk-on, risk-off, safe harbour, managing expectations, flight to safety, volatility index spike, economic slowdowns, liquidity issues, consumer sentiment, difference in put and call option percentage ratios, and inverted yield curve are among indicators of changes in capital markets.
Since no one can predict with prescient clarity what will happen at any given hour or day on any massive investment trading platform, there are generally, well-coordinated defined strategies in place for the safety of finance institutions and their clients’ investment assets.
Protective measures will be called into action: selling riskier assets (stocks and the like), then moving money to more conservative, safer allocations — in this case sovereign debt — all considered high-grade, low risk securities.
The US, UK, Canada, Switzerland, Japan, and Germany’s sovereign debt (bonds) are examples of debt securities issued by the most stable economies in the world.
Reacting to market signals, investors may become so concerned about parking assets in safety that they will pay far more than the ordinary market price for a considerably safer investment, driving up values, and lowering yields, sometimes significantly.
Here is where we rotate back to the recent discussion of bonds, specifically US Treasuries, still considered the safest, most liquid investment asset, and reserve currency, in the world.
What is a US Treasury yield curve and why do we care?
In simple terms, an inverted yield curve is an indicator of serious investor concerns about current market conditions, and can signal a recession at some point.
Here is a quick refresher on US Treasury note/bond structures and how a yield curve works.
• US notes and bonds are issued in different terms of maturity: two, ten, 30 years, etc
• The coupon interest rate on a bond, issued at par (100) does not change, but the yield does — depending upon the price paid for the note/bond in open markets.
• As the maturity of the notes (and the 30-year bond) go up the curve, the interest rate and the yield on each notes’ maturity will reflect, similarly, a normal yield curve. See Chart 1.
• Short maturity — say the two-year T-note, which as of one day last week offered a coupon rate of 1.5 per cent annually.
• Mid-long maturity: the ten-year T-note with higher coupon interest rate of 1.63 per cent, annually.
• Much longer-term debt — the 30-year US bond offering 2.25 per cent, annually, to incentivise investors to purchase and hold this debt.
In the chart 1 example, a normal yield curve is shown by the dotted blue line, with the yield lowest on the shortest maturity note, for instance the two-year note, and the yield increasing as the maturity date lengthens, for instance ten-year notes and beyond.
However, last week’s yield numbers are not a normal yield curve at all.
• Two-year yield at 1.50 per cent, the same as the coupon rate.
• ten-year yield at 1.46 per cent, less than the two-year note yield and less than the ten-year coupon interest rate of 1.63 per cent. Immediately, we know this note is selling at premium over par of 100 — it is in demand and more importantly, the yield is below the two-year note.
• 30-year yield at 1.93 per cent, significantly less than its coupon interest rate of 2.25 per cent.
We know from these numbers that investors are buying the ten-year and 30-year notes in droves and paying premium prices.
In chart 1, the dotted yellow line shows the yield “apple cart” upside down, or inverted. The longer-term ten-year T-note drops lower than the two-year note yield, a reflection again of safety at almost any price.
Chart 2 illustrates the number of times the US yield curve has inverted prior to a recession. A CNBC article, which you can find a link to at the end of this week’s column, does a very nice job of explaining these concepts further.
Bonds trade in the trillions every day. It is a market more than five times the size of equity markets. Bonds can be safe, conservative, middle of the road risk investment grade, or high-yield high risk to just-about-junk bonds paying large interest rates.
For every level of risk there is additional compensation in higher interest rates. But, the overall answer to the question of choices is the same. Will I get my money back?
Self-explanatory, the reason that flight-to-safety occurs so highly-geared towards the US trading markets is because investors know they will get their principal back. And this is not just a US phenomenon, the yield curve has also inverted in the UK and Canada in recent weeks.
Readers, this is complicated, so please write to me with your questions.
Next, what happens to investors who have paid price premiums on bonds, but later want to sell their high-priced bonds when uncertainty is mitigated?
And, why would anyone want to buy a bond with a negative yield?
• CNBC: Main yield curve inverts as two-year yield tops ten-year rate, triggering recession warning August 21, 2019 Thomas Franck https://tinyurl.com/y2aw2wpz
• Reuters: What is an inverted yield curve? https://tinyurl.com/ybh2f3wb
• Wikipedia. https://en.wikipedia.org/wiki/Yield_curve
Martha Harris Myron CPA CFP JSM: Masters of Law — international tax and financial services. Dual citizen: Bermudian/US. Pondstraddler Life, financial perspectives for Bermuda islanders and their globally mobile connections on the Great Atlantic Pond. Finance columnist to The Royal Gazette, Bermuda. All proceeds earned from this column go to The Reading Clinic. Contact: email@example.com
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