# Inverted Yield Curve Explained

Home/Inverted Yield Curve Explained

## Inverted Yield Curve Explained

The Inverted Yield Curve sounds like a complex technical economic term which only city insiders and serious economists could possibly understand. Well that’s perhaps what they would like you to think and believe. But surprisingly its actually one of the simpler and easy to recognise economic calculations. It would be true to say however, that’s its impact and predictive qualities require a little more analysis and understanding.

We are going to give you a few definitions here of what an inverted yield curve is – all of which basically means the same thing:

• An inverted yield curve occurs when long-term yields fall below short-term yields.
• An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality.
• An inverted yield curve marks a point on a chart where short-term investments in U.S. Treasury bonds (for example) pay more than long-term ones.
• Normally, someone who lends to the government or a corporation for one year (by buying a one-year government or corporate bond) would expect to get a lower interest rate than someone who lent for five or ten years, making the yield curve upward-sloping – that is the longer the time period the higher the rate. When short term rates are longer than long term rates, that slope rather than going up goes down and therefore it is inverted.

So, let’s take one step back. What is a Yield Curve?

The yield curve is a plot of interest rates for government bonds of all maturities in a given country.

It is essentially a graph showing the relationship between interest rates earned on lending money for different durations.

Under normal circumstances, if you were to lend money, as banks do, you are likely to charge a lower rate of interest if you were lending over a short term compared with lending for a longer term.

Let’s explain why – If I were to lend you \$10,000 for 12 months – I take into account the following factors:

1. The likelihood of you being able to pay me back
2. What interest I could have got on that money elsewhere during that 12-month period
3. What other investments I am not able to take advantage of while you have my \$10,000
4. What treat I could have bought myself with that \$10,000 which I have to delay having because you have my money.

So, because it’s a relatively short period of time, and the risk is relatively low, I will charge you say 6% for the money – which is cheaper than a credit card but much more than I am getting from a bank.

Now let’s say you wanted to borrow that \$10,000 for 5 years.

Now I still have to take into account the factors mentioned above, but my costs and risk have now increased.

I risk the fact you may disappear with my money

I risk the fact you may die and there is no-one I can claim from

I risk the fact that over 5 years your circumstances and financial situation could deteriorate, and you won’t be in a position to pay me back.

I risk the fact the dollar could devalue in that time so my money will buy less.

I risk the fact that interest rates could rise during that period and I could have earned more on my money than I am earning today

I also have to suffer a prolonged period of not being able to use that money for either, other forms of investment opportunities or to buy that Rolex watch I’ve always wanted which in 5 years could cost considerably more than it does now.

So, taking these factors into account I am now going to charge you 10% interest per annum rather than 6% to compensate me for the above.

So, this is why generally longer-term rates are higher than short term rates charged by banks.

When an inverted yield curve is created, all of this is turned on its head.

You are now being charged more short term than you are long term.

Now I can hear you ask so what? Why does this matter?

Well think about it. What does this signify.

In simple terms its basically saying to me, that interest rates are likely to fall in the future. It signifies that inflation is likely to be lower in future. It signifies that if I want to borrow short term I have to pay more.

So, as a business what is your response likely to be? The answer is, put off any borrowing until those rates fall. Put off any investment until inflation falls and costs are lower. Put off any immediate borrowing as it will be cheaper to borrow and invest later on.

It is for this reason that generally when there is a yield curve inversion, it normally predicts a looming recession because borrowing and investment is delayed and demand for goods reduce and thereby the economy slows down.

Now this is a simple explanation. It is a little more detailed than this as there is quite extensive financial modelling behind these conclusions – but I am sure you get the point.

So, going back to last Wednesday, August 14th the yield on the 2-year U.S. Treasury note had risen above that on the 10-year U.S. Treasury note – the yield on the benchmark 10-year Treasury note was at 1.623%, below the 2-year yield at 1.634%.

Just as a quick aside, a US Treasury Note is an intermediate-term interest-bearing bond issued by the US Treasury. It’s a marketable U.S. government debt security with a fixed interest rate and a maturity between 1 and 10 years. In simple terms they are Bonds Government issues to receive capital and the interest rate is the rate it has to pay for that capital. These bonds are then either held until maturity or sold in what is called the secondary market.

The last inversion of this part of the yield curve was in December 2005, two years before a recession brought on by the financial crisis.

According to Credit Suisse a recession occurs, on average, 22 months following such an inversion.

The Federal Reserve and other central banks have consistently referred to the fear of deflationary pressures as the biggest worry facing financial markets.  Wednesday’s bond markets tell us that inflation is going to be much lower in 2029 (10 years from now) than it is in 2019.

This is one of the key interpretations of an inverted yield curve.  Inflation expectations for future periods are lower and that can only mean a slowing, and perhaps contracting, global economy.

This is why the major headlines emphasised the fact that an inverted yield curve is a classic signal of a looming recession. The U.S. curve has inverted before each recession in the past 50 years. … When short-term yields climb above longer-dated ones, it signals short-term borrowing costs are more expensive than longer-term loan costs.

As already mentioned, under these circumstances, companies often find it more expensive to fund their operations, and executives tend to restrict or completely shelve investments. Consumer borrowing costs also rise and consumer spending, which accounts for more than two-thirds of U.S. economic activity, slows. The economy eventually contracts, and unemployment rises.

The general consensus amongst seasoned investors is that when the yield curve inverts, one should sell their stocks and shares; as their value is based on growth, and the major equities such as  Amazon, Facebook, Apple, etc. have all been built on rapid rates of growth in revenues and earnings.

If the bond market is telling us the global economy is slowing, the stock market should price in lower rates of growth for individual stocks.  That is why shares of those major companies in particular—and the vast majority of stocks around the globe—fell sharply on Wednesday – in fact the Dow fell by 800 points and some traders were expressing the experience as ‘carnage’.

It recovered almost 100 points yesterday but this fear factor is unlikely to go away.

Added to this, we have to be mindful that the global economy in 2019 is based on access to credit, and it has been for the past 50 years.  If credit conditions dry up, we could easily see a meltdown in 2019 as we did in 2008-2009.

The reason this is a distinct possibility and why we have been somewhat critical of Trump’s tariffs is China.

China’s economy was barely dented by the financial crisis that affected Western economies in 2008-2009, but today it is just as dependent on credit as that of the U.S. and in fact more so, by certain measures.

In December 2008 the total assets of the Chinese financial system were \$9.1 trillion.  That compared to \$12.2 trillion in U.S. financial system assets. As of June 30, 2018, the latest data available, Chinese financial system assets totalled \$39.0 trillion dwarfing the U.S.’ total of \$17.5 trillion.

According to Financial Journalist and Forbes contributor Jim Collins:

“That’s why pictures of protestors occupying the airport in Hong Kong are so scary.  That’s why the Chinese government’s decision to let the yuan/dollar exchange rate rise above 7:1 (making Chinese financial assets worth less in dollar terms) is so scary.  That’s why President Trump’s trade tweets can and will move the markets significantly—in either direction. Anything that makes Chinese companies less likely to repay their loans is a decided negative for global bond markets.  Each of those three factors certainly qualifies. That’s also why the yield curve in the U.S. has inverted.  Any measure of U.S. current economic activity or financial system liquidity looks fine or even better than fine.  But the bond market looks like the world is in the middle of a global catastrophe. Why? Because global markets are interlinked.”

So, it is highly likely therefore that the bond market and its inverted yield curve are telling us that economic growth is slowing—or perhaps even contracting.  The valuation of stocks, above all else, depends on estimates for rates of earnings growth. With this in mind, it is little wonder that seasoned investors have been selling stocks.

We all know from past experience that when funds leave the stock market and fear sets in, often we see at least a proportion of those monies head into safe haven assets such as gold and occasionally silver as gold becomes increasingly expensive. It also tends to have a negative impact on the US dollar value, at least short term, which also increases the price of gold and silver. This we saw on Wednesday when gold jumped from \$1495 to \$1522 and silver from \$16.88 – \$17.37 though they are currently standing at \$1,512 and \$17.16 respectively.

Now before you rush out and fill your safes and homes with gold and silver, as it appears that we are saying that a recession is about to begin – we also have to add that there is another side to this coin and that its not all negative stocks as would first appear.

Whilst it is true that weak economic data and low inflation around the world, trade conflicts, and political tension in places such as Hong Kong have sparked worries about global growth, fuelling market expectations of central bank interest rate cuts and triggering steep falls in government bond yields and that the U.S. curve has inverted before every recession in the past 50 years, offering a false signal just once in that time; not every fund or portfolio manager is convinced that a recession is imminent.

Remember we mentioned that Credit Suisse stated that a recession occurred within 22 months on average, well some investors believe that the economy is actually stronger than many fear, and that the immediate future is nowhere near as bleak as many pundits are making it out to be.

Capital Economics have stated for example:

“Inverted yield curves in the US and elsewhere tell us very little about the timing of future downturns and, for now at least, the economic data are more consistent with a slowdown than a downturn in the world economy,”

Yesterday for example, quite a large amount of economic data was published as we highlighted in our weekly update on Sunday. Retail sales for July were up 0.7% against an expectation of 0.3%. productivity from Q2 was up 2.3% against expectations of 1.7% and retail sales excluding automobiles were up 1% in July compared with expectations of just a 0.5% rise.

These figures are not terrible and not indicative of an imminent recession.

MUFG Managing Director and Chief Economist Chris Rupkey has commented:

“This is not what a recession looks like. We know. We checked it. The rule of thumb for recession is three consecutive months of declining retail sales ”

And BMO Chief Investment Strategist Brian Belski said on CNBC’s Fast Money Halftime Report:

“The yield curve matters when it inverts over a several-week, if several-month, time period. We had an intraday inversion. In 1998, we had a 27-day inversion……Just because everyone thinks we’re going to have a recession doesn’t mean we’re going to have one. Saying we’re going to have a recession is saying the sun is going to come up tomorrow. Of course we’re going to have a recession at some point,”

UBS said in a note to clients and we think its worth quoting it here in full:

“Bond yields signal recession risk, we say not so fast. … Unlike trade conflicts, an inverted yield curve by itself has limited economic impact. Instead, its signal about the health of the economy is what matters, and it is not as negative as some investors fear. For one, there’s been a long and variable lag between initial inversion and the start of recessions: 22 months on average, ranging from 10 to 36 months for the last five recessions. In addition, Treasury yields are being weighed down by the almost USD 16 trillion in sovereign bonds globally with a negative yield, distorting their signal about US economic activity. Finally, the length of time the yield curve is inverted, and how much is inverted, matter. If Fed rate cuts successfully steepen the curve comfortably into positive territory, this brief curve inversion may be a premature recession signal.”

So, what are we all to think? There is no doubt that an inverted yield curve has occurred. Traditionally it has led to a recession but generally its been many months and in some cases a couple of years before it has happened. We all know there is a US Presidential election in 2020 and you an bet the current administration is going to do all that it can to make sure the economy is humming or at least not declining – this is partly why President trump has delayed many of the proposed increases in China tariffs until December and we should not be too surprised if he starts making more positive overtures to China for the reasons we stated earlier.

From our own modelling, which of course does not have the immediate up to date detailed data that government statisticians have access to, suggest that if a recession does occur its more than likely to happen in 2021.

Whether we like it or not,  modern monetary theory or more money printing will continue to put off that inevitable day of reckoning and whilst we may see deteriorating economic figures or less robust growth, we could find ourselves in another multiple year period of above marginal growth whilst the liquidity permeates throughout the economy and the world.

In terms of gold and silver, we may see some pullbacks, but can be moderately confident that their prices are relatively underpinned with the short-term medium outlook for lower interest rates ahead. The future however is, to a large extent, determined, at least short term, on the actions that President Trump takes and to what extent he manages to reduce the disruption caused via his twitter feed.

What happened on Wednesday is a reminder to all those who have responsibility for economic policy that actions have consequences and they have to be carefully thought out and implemented deliberately – as there are black swans circling and the number are increasing.

Inverted Yield Curve Explained – Stocks, Gold & Silver Price Ramifications

By |August 17th, 2019|