Is the Yield Curve predicting another Financial Crisis?

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The yield curve has predicted seven out of seven recession in the past 50 years, a perfect forecasting track record. It is no wonder investors are concerned when looking at the current yield curve as it seems another recession is looming.

Explaining the Yield Curve

A yield curve in a graph shows the relationship of different bonds' interest rates of similar risk but with different maturity date. On the x-axis, it is the maturity date of the bond while on the y-axis, it is its interest rate. For the purpose of illustration, we will use US Treasury bond as it is perceived as risk free due to it being backed by the USA government.

Every bond has an interest rate that shows the return required by the investor who wants to invest in it. For example, USA 10-year Treasury bond is currently at 3%. This means that investor who bought the bond will receive 3% return every year for the next 10 years. Interest rates usually reflects the risk of the investment. For example, higher interest rate means higher risk and vice versa.

Generally, a long term bond will have a higher interest rate as compared to a short term bond. This is due to the thinking that because you are committed to invest longer, there is higher chance of you losing the money and therefore higher risk. During normal economic condition when investor expect economy to grow at normal pace, short term bond interest rate will be lower than long term bond interest rate, resulting in a positive yield curve as shown below.

Positive Yield Curve

The positive yield curve can steepen, meaning that long term bond interest rate rise faster than short term bond, and this usually happen during bullish market condition. In a bullish economic environment, companies are expected to do well and may proceed with their expansion plan. This will result in lower unemployment and rising wages. There is also ample liquidity in the market as banks are willing to lend money to consumer and companies to spend and invest at low interest rate. The increase wealth will results in higher consumption. This increased demand for limited supply of goods will result in higher inflation.

Inflation is not good for investors who wants to invest in long term bond. This is because if inflation is expected to increase faster, holding on to long term bond will result in lower net interest return. To illustrate, today you invest in a 10 year 3% bond with current inflation of 1%. Your net return is 2% by the end of year 1(3% - 1% = 2%). Say 5 years down the road, if inflation accelerated and hit 5%, your net return will be -2% (3% - 5%= -2%). Therefore in an inflationary environment, demand for long term bond will decrease and in order to entice people to buy long term bond, its interest rate has to increase so that it will provide sufficient return to the investors.

For investors investing in short term bond, accelerating inflation will not impact them greatly as their bond will mature in a matter of months and by then, they can reinvest their capital into higher yielding bonds if the opportunity arises. Short term bond investor would therefore be less demanding on requesting for very high interest rate. So during bullish economic condition, long term bond yield will expand at a faster rate than short term bond resulting in a steepening of the positive yield curve.

Inverted Yield Curve

With expected higher inflation, central banks will start to increase its interest rates so that it will make it more expensive for people and companies to borrow money, thus curbing inflation. This will cause economic environment to slow down. With the view that market condition has become more uncertain with risk of recession, bond investors will start to turn their investment into long term bond. The reason is it provide a safe place for investors to put their money in amid falling equities markets and volatile environment. As long term bond interest rate is currently high, investors will want to lock in the high yield before they decrease further. As demand for long term bond increase, investors will be less demanding on the interest rate and therefore it will start to fall. This may result in long term bond yield falling below short term bond yield, forming an inverted yield curve.

Well you may ask who would want to invest in a 10 year Treasury bond that give a lower interest as compared to a 2 year Treasury bond. Let me illustrate with the following example:

Assuming today is 4th of July 2000 with the 2 year Treasury bond and 10 year Treasury bond at 6.38% and 5.86% respectively. Also assuming that after your 2 year Treasury bond mature, you will reinvest it in another 2 year Treasury bond at the interest rate at that point of time. Even though the 10 year Treasury bond has an initial lower interest than 2 year Treasury bond in year 1, over the course of 10 year, the return for 10 year bond is higher as investor has locked in the higher interest rate already.

Historical Trend

An inverted yield curve usually signal a recession is on the horizon. In the past, the US Treasury yield curve inverted before past recessions such as the 1981 and 1991 recession, dot-com bubble in 2000 and the global financial crisis in 2008. The graph above shows the difference between 10 year US Treasury bond interest rate and 2yr Treasury bond interest rate. When the blue line is below the grey line of 0, it means 10 year bond interest rate is lower than 2 year bond interest rate, which also means an inverted yield curve. As we can see the inverted yield curve is subsequently preceded by recessions which is represented by the background highlighted in grey.

Also from the graph, we can see that there is a lag between the negative spread before the onset of the recessions. During the 2008 global financial crisis, 3 months after the spread turned into sustained positive territory from negative, the Dow Jones Industrial Average starts its slide into bear market. As for during the dot com bubble, it happened after 5 months from the onset of sustained positive spread.

Current Trend

Currently, the difference between 10 year and 2 year Treasury bond is at positive 0.5% but continue to trend downwards. This is in spite of 10 year Treasury bond yield having continued to rise and touched 3% but short term bond is rising at an even faster rate. Are we heading for another inverted yield curve and subsequent recession or will this time be different? We shall see.