I have money on hand and I want to put it into something safe. The US government is constitutionally bound to pay its debts, and is generally considered to be very safe (if not the safest investment around).
The US government sells bonds with different terms. I can buy 1 year bonds, 3 year bonds, 5 year bonds, 10 year bonds, etc. The treasury sets a fixed interest rate and face value on treasury notes and then whoever pays the most gets the note.
Right now, (annualized) rates [1] are approximately as follows:
1 month - 2.30%
6 month - 2.56%
1 year - 2.72%
3 year - 2.84%
5 year - 2.83%
7 year - 2.90%
10 year - 2.98%
Notice that the 3 year rates are higher than the 5 year rates. Generally speaking, if I'm going to lock up my money for more time, I expect a higher return. However, today, the 3 year notes are getting a higher rate of return than the 5 year notes. Why?
Interest rates generally tend to follow the economy at large. When the economy is doing well, people will invest in stocks and other investments and are less willing to pay for the safety of treasuries, so effective rates go up when people bid less at treasury auctions (additionally, the government will take steps via the Federal Reserve to make rates higher). By the same token, when the economy isn't doing well, people want the safety of treasuries, even if they pay less, so effective rates on treasuries tend to go down.
In rare cases, the yield curve will invert. What this means is that investors think that rates of return on government bonds are going to go down in the future. In order to lock in a better rate now, they're willing to pay more for longer term bonds (in this case, 5 year bonds vs. 3 year bonds) in order to "lock-in" the good rates. The assumption is that they won't be able to get the same good rates if they don't act now.
Note that only the 3 and 5 years have inverted. If people were really panicked, you would probably see a more significant inversion, where for example, the 1 year was higher than the 2 year and the 2 higher than the 3, etc.
[1] these rates are actual rates of return calculated based on the auction price paid
As far as insight for how this looks for the US economy, one of the few people I respect when it comes to predictions is Ray Dalio, he says the US debt will start becoming an issue soon. Within 10 years the majority of the US federal budget will go to paying INTEREST on our debt, requiring us to borrow more to pay for the rest which will result in exponentially rising debt and inflation as the government prints money.
Dalio also talks about Thucydides Trap and Paul Kennedy's book on the decline of great powers. He doesn't say it but he seems fairly confident in China surpassing the US as the dominant global power in the near future. The only issue I have is that he seems to think China's high debt is fine compared to the US based on vague reasoning.
The US and the West in general need to wake the fuck up or we're going to be under China's thumb. We've become complacent and assume our status on top of the global hierarchy is guaranteed. China is playing to win and doesn't care about breaking the rules to win
Nice write up. But I want to point out that interest rates are leading indicators of the economy, it doesn't follow the economy.
It's why the inverted yield curve is one of the widely looked at indicators for future economic health.
So the yield curve inversion isn't saying the economy right now isn't doing well. What it is saying is that the market ( or a large percentage of institutional investors ) think the economy won't do well in the future.
As you noted, it's only a slight inversion of only the 3 and 5 year, so it isn't that alarming for the moment.
Just as important as the yield curve is what the FED is going to do with interest rates. If they consistently raise it every quarter for the foreseeable future, then the odds of a recession will increase considerably.
So if we look at the very long term rates, do those signal that we are broadly confident that the US economy will be healthy long term? Or is there no signal there?
With regards to
> that investors think that rates of return on government bonds are going to go down in the future.
Does it mean that investors think that US government will pay 'less interest' in the future for these 5 year bonds ?
If yes, does that mean that investors think that US government will be willing to pay less to its lendors
(the bond holders).
Which, would also mean that bond buyers think it is good
time now to lock in a higher rate.
(seems like a good thing if one is a US taxpayer, if the gov will pay less to money lenders, unless US people are starving...).
>The treasury sets a fixed interest rate and face value on treasury notes and then whoever pays the most gets the note.
Its important to point out that these are not market-based auctions. The Federal Reserve regularly steps in to purchase its own bonds (in effect skewing the price of the auction). The FED currently holds ~4 trillion worth of bonds purchased in prior auctions (its not currently increasing its holdings but it is repurchasing).
Central bank purchasing their own bonds can act to prop up the market, but also to disrupt market forces by keeping a "thumb on the scale". While this was initially done as an attempt to stimulate the markets after the crash of 2007/2008, it was never ceased, putting the whole financial system into real jeopardy when there is another crash and central banks have used up all of their bullets. This is a financial experiment with an uncertain end. The balance sheet of the BOJ as recently passed its annual GDP.
OK, I have a (probably stupid) question. If the 3-month T-bond rate is say 2.32%, does that mean that I can buy such a 3-month security 4 times in a row in a given year to get a total of 4 * 2.32 = 9.28% ROI on the money I am using to invest? Actually, the return would technically be higher than since the second, third and fourth times I am buying the T-bond I will use not only the original cash I had on hand but also the 2.32% return I received each time I bought the T-bond. So, assuming everything is re-invested in the 3-month T-bond the total ROI for a given year would be about 9.6% (assuming the rates stay the same of course).
A ROI of 9.6% is quite good and beats stock market return over most years, while also being virtually risk-free.
Am I missing something here? Why invest in a (risky) stock market unless you can reasonably expect a return in the double digits that can compensate for the extra risk, compared to a 9.6% risk-free ROI from T-bonds?
Please pardon my ignorance and thanks in advance.
How well does the U.S. yield curve perform as a prediction market for S&P 500 prices? Is there a strong correlation between what investors expect will happen in 3-5 years (ie the yield curve), and what actually happens?
I think it's more common in developing nations. I saw this when doing fixed deposit in India and was very surprised. It makes sense as it is expected that the safety of the investment will increase as the country develops and the interest rate is likely to fall, as it is currently three times as that of US.
Shorter summary - historically, yield curve inversions have been pretty reliable predictors of recession.
There are no certainties, of course, but the probability is pretty high that in the next 6 to 24 months we'll see negative economic growth and increasing unemployment.
Great write up. Also in layman's terms: what do investors generally do when gearing up towards a recession, other than buy long-term (and low-yield) bonds in advance?
Capital One is offering money market savings accounts earning 2.0%, with no caps, and no time limits. Sure, I could buy a 1 year bond, and earn the extra .72%, but I rather have the flexibility to withdraw at anytime with the Capital One money market account.
There is a 1 bps spread between the 3-year and 5-year US Treasury (2.84 vs 2.83) as of close of market today.
While somewhat noteworthy, it's not huge (yet). When people talk about yield curve inversion and it being an indicator of recessions, it's much more common to compare the 2-year with the 10-year. Currently that sits at 2.83 (2yr) vs 2.98 (10yr). While the shorter spreads do often invert first, there is no requirement for the longer spreads to follow.
Meaning they take short-term deposits (e.g. current account balances) and make long-term loans (e.g. mortgages). They normally make a profit, because they borrow short paying low rates, and lend long receiving high rates. Easy. Head to the golf course.
If the yield curve inverts, banks lose money ... their capital ratios and share prices fall ... they become more risky and less creditworthy ... people withdraw their money ... bank runs, ATMs stop working, bail-ins ... your current account is permanently unavailable (see Cyprus, Greece).
Note that many banks, especially European banks, are starting from an existing almost-bankrupt state, with plummeting share prices (DB, UniCredit, BBVA, BNP). If the EUR yield curve inverts, they all crash faster than an anvil without a parachute (DB is already giving the anvil a good race).
Can someone explain this in dumb person language? All I get is that the yield that bonds give is below zero, meaning you lose money holding them? And bonds are buying debt on faith the issuer will pay, and as the issuer pays, you get dividends.
And I think the interest rate is inversely proportional to the amount the bonds pay or something like that?
Not quite that. The yield for a 5-year note is less than the yield for a 3-year note.
More generally, a yield curve inversion is when the interest rate you earn on short-term debt ends up higher than that of long-term debt of the same quality.
I don't think the issue is that the inversion causes the recession. It's more an indicator of pessimism in the market. It implies that investors think that interest rates are going to get worse, so they look to buy more longer-term bonds in order to try and lock in current yields for a longer period of time. That increases demand for those assets, which drives down their price^H^H^H^H^H yields.
Actually they still pay a positive amount (about 2.8%/year). What's significant is that now the 3 year pays slightly more than the 5 year (2.84% vs 2.83%). Usually longer term treasuries pay more because the buyer assumes more risk to have their money locked in to a specific rate for a longer term.
However, when the market expects that maybe interest rates will be falling in the near future (like in a recession), it can prefer to lock in the current rates for a longer term. When markets expect recessions, people tend to buy long term treasuries over short term treasuries which causes the yield of long term treasuries to go down and the yield of short term treasuries to go up.
If my understanding it correct, I'm pretty sure it means the yields of short-term investments are better than long-term investments with the implication that investors feel like the economy is fine now but won't be in the not to distant future. In short, they think there will be a recession so they want to make money now while the gettin's good.
A 5-year bond now has a lower yield than a 3-year bond? How is that even possible? Wouldn't anyone who wants a 5-year bond just buy a 3-year bond and then put the cash under their mattress after 3 years?
Is the idea that in 3 years' time, negative interest rates will be widespread, physical cash will be abolished, and figuratively keeping the cash under your mattress isn't even possible?
EDIT: And why don't arbitrageurs buy up 3-year bonds and sell 5-year bonds?
Worth noting that unlike previous business cycles the Fed is manipulating both the long and short end of the curve. Quantitative Tightening (QT) is the Fed's program to sell and/or let expire the long-term Treasuries it bought during QE 1/2/3.
As the same time, the Fed is raising short term interest rates using its tried-and true headline short-term interest rate target.
This is not just unusual - it's unprecedented. QT has the effect of suppressing the yield curve inversion signal (by artificially increasing long-term rates). As a result, the gap between the next yield curve inversion (the one mentioned in the article hardly qualifies) and the next recession could be surprisingly short.
Backing off now on QT and short term raising, with unemployment at a very low point and inflation ramping up, would be lethal to the Fed's credibility. Whatever Powell says to try to talk the stock market up, he's locked and loaded and can't do much beyond stick with the program: triggering the next recession.
Question: Are there any other recession signals which have also recently presented themselves? I know very low unemployment, which we have, is one. Are there others?
I've heard that container shipping, and container shipping fleet expansion are important indicators, but I've also read that it went haywire in 2008, and the tradewar isn't helping.
a better way to understand the causality between yield curves and recessions is to look at it from the perspective of the banking sector ... banks/lenders primarily borrow short-term and lend long-term. They pay depositors short-term rates and earn the long term rates on loans. If this carry trade turns negative, it makes it difficult to make money lending, they get more conservative and collectively they tighten credit conditions on the economy as whole.
> All it means is that the central bank will probably leave interest rates steady, or even cut a bit, in 2022 or 2023.
This event reflects the relative preference of the markets for the 5 yrs compared to 3 yrs, producing lower effective yields. This is probably done to secure a certain rate for a longer period of time.
One thing I'm interested to see if anyone can discuss what's different this time (i.e, Fed has ~4x more assets on it's balance sheet [and the roll-offs], corporate have ~2x more debt, labor force participation rate is at levels not seen since the 60's, 4 eurodollar "events" since, US gov debt levels since) and how it could theoretically affect the yield gymnastics?
Some banks keep saying 2020 is the big one since that's when most of the corporate debt will be need to rolled over onto higher rates, but I'm of the mind we don't even make it that far because of even shorter term liabilities (think corporate buybacks with debt at higher rates that will increasingly put pressure on balance sheets m/m, liquidity pressure risk assets, devaluation on collateral) in this environment.
It doesn't have to be this way. The curve was unnaturally flat to start with due to Operation Twist. As the Fed unwinds its balance sheet, it seems only naturally to also unwind the effects of Operation Twist at the same time.
Can someone concisely explain what yield curve inversion could indicate?
I can think of a few explanations for why long term yields are going lower:
1. Long term yields going lower because there are far fewer places for capital to go to besides US treasuries, indicating slower business activity
2. Short term yields going higher because no one wants to buy short-term treasuries because there's something else to invest in or expect higher return for short term investment?
Are these the only two reasons? Why are people so fearful of inverted yield curves?
All those Princeton and Harvard economists travelling the world telling foreign governments how to run their economy lol. Does any politician in the US even read the emails the Fed sends them? Must be the most thankless job ever.
Based on past patterns, we now have about 15 months before a formal recession is declared. This is rough and imperfect, but many other metrics are pointing to both the end of the bull market and a coming recession. I've been monitoring the econ because I plan to invest in real-estate and stocks during the next slump. [Corrected "bear" typo.]
>"I've been monitoring the econ because I plan to invest in real-estate and stocks during the next slump."
Which raises the question of "isn't every other investor?" And if that's the case, how much of that has the market already factored into pricing?
For example, I hear a lot of people in the Bay Area talking about saving up for when the next crash occurs so they can buy real estate cheap. But if there's sufficient pent up demand and capital, that can dampen the impact like what appears to have happened with the 2008 recession[1], only perhaps magnified after this bull run.
Keep in mind the next recession may very well not have anything to do with real estate. We also just went through a prolonged period of record low interest rates during which you could finance real estate really cheaply (though prices could have been inflated from excess demand, but [a] I'm no real estate expert and [b] this could vary significantly from location to location).
[+] [-] chadash|7 years ago|reply
I have money on hand and I want to put it into something safe. The US government is constitutionally bound to pay its debts, and is generally considered to be very safe (if not the safest investment around).
The US government sells bonds with different terms. I can buy 1 year bonds, 3 year bonds, 5 year bonds, 10 year bonds, etc. The treasury sets a fixed interest rate and face value on treasury notes and then whoever pays the most gets the note.
Right now, (annualized) rates [1] are approximately as follows:
1 month - 2.30% 6 month - 2.56% 1 year - 2.72% 3 year - 2.84% 5 year - 2.83% 7 year - 2.90% 10 year - 2.98%
Notice that the 3 year rates are higher than the 5 year rates. Generally speaking, if I'm going to lock up my money for more time, I expect a higher return. However, today, the 3 year notes are getting a higher rate of return than the 5 year notes. Why?
Interest rates generally tend to follow the economy at large. When the economy is doing well, people will invest in stocks and other investments and are less willing to pay for the safety of treasuries, so effective rates go up when people bid less at treasury auctions (additionally, the government will take steps via the Federal Reserve to make rates higher). By the same token, when the economy isn't doing well, people want the safety of treasuries, even if they pay less, so effective rates on treasuries tend to go down.
In rare cases, the yield curve will invert. What this means is that investors think that rates of return on government bonds are going to go down in the future. In order to lock in a better rate now, they're willing to pay more for longer term bonds (in this case, 5 year bonds vs. 3 year bonds) in order to "lock-in" the good rates. The assumption is that they won't be able to get the same good rates if they don't act now.
Note that only the 3 and 5 years have inverted. If people were really panicked, you would probably see a more significant inversion, where for example, the 1 year was higher than the 2 year and the 2 higher than the 3, etc.
[1] these rates are actual rates of return calculated based on the auction price paid
[+] [-] beginningguava|7 years ago|reply
Dalio also talks about Thucydides Trap and Paul Kennedy's book on the decline of great powers. He doesn't say it but he seems fairly confident in China surpassing the US as the dominant global power in the near future. The only issue I have is that he seems to think China's high debt is fine compared to the US based on vague reasoning.
The US and the West in general need to wake the fuck up or we're going to be under China's thumb. We've become complacent and assume our status on top of the global hierarchy is guaranteed. China is playing to win and doesn't care about breaking the rules to win
[+] [-] porpoisely|7 years ago|reply
It's why the inverted yield curve is one of the widely looked at indicators for future economic health.
So the yield curve inversion isn't saying the economy right now isn't doing well. What it is saying is that the market ( or a large percentage of institutional investors ) think the economy won't do well in the future.
As you noted, it's only a slight inversion of only the 3 and 5 year, so it isn't that alarming for the moment.
Just as important as the yield curve is what the FED is going to do with interest rates. If they consistently raise it every quarter for the foreseeable future, then the odds of a recession will increase considerably.
[+] [-] Waterluvian|7 years ago|reply
So if we look at the very long term rates, do those signal that we are broadly confident that the US economy will be healthy long term? Or is there no signal there?
[+] [-] 75dvtwin|7 years ago|reply
With regards to > that investors think that rates of return on government bonds are going to go down in the future.
Does it mean that investors think that US government will pay 'less interest' in the future for these 5 year bonds ?
If yes, does that mean that investors think that US government will be willing to pay less to its lendors (the bond holders). Which, would also mean that bond buyers think it is good time now to lock in a higher rate.
(seems like a good thing if one is a US taxpayer, if the gov will pay less to money lenders, unless US people are starving...).
For example, Ukrain's 3 year bond pays 18%
http://www.worldgovernmentbonds.com/bond-historical-data/ukr...
[+] [-] StanislavPetrov|7 years ago|reply
Its important to point out that these are not market-based auctions. The Federal Reserve regularly steps in to purchase its own bonds (in effect skewing the price of the auction). The FED currently holds ~4 trillion worth of bonds purchased in prior auctions (its not currently increasing its holdings but it is repurchasing).
https://www.federalreserve.gov/monetarypolicy/bst_recenttren...
Central bank purchasing their own bonds can act to prop up the market, but also to disrupt market forces by keeping a "thumb on the scale". While this was initially done as an attempt to stimulate the markets after the crash of 2007/2008, it was never ceased, putting the whole financial system into real jeopardy when there is another crash and central banks have used up all of their bullets. This is a financial experiment with an uncertain end. The balance sheet of the BOJ as recently passed its annual GDP.
https://www.reuters.com/article/us-japan-economy-boj/bank-of...
[+] [-] haidut|7 years ago|reply
[+] [-] NTDF9|7 years ago|reply
What about the fact that US treasury is issuing more bonds to fund extremely large deficits? How does that play into the equation you described?
Wouldn't so many bonds flood the market with bonds available and thus raise the yield rates on 10-year?
[+] [-] coffeemug|7 years ago|reply
[+] [-] YetAnotherNick|7 years ago|reply
[+] [-] dskhatri|7 years ago|reply
[+] [-] panarky|7 years ago|reply
There are no certainties, of course, but the probability is pretty high that in the next 6 to 24 months we'll see negative economic growth and increasing unemployment.
[+] [-] gota|7 years ago|reply
[+] [-] tanilama|7 years ago|reply
[+] [-] nodesocket|7 years ago|reply
[+] [-] rafkin98|7 years ago|reply
[+] [-] c3534l|7 years ago|reply
Since when? Please point me to the part of the constitution that says that.
[+] [-] unknown|7 years ago|reply
[deleted]
[+] [-] gibybo|7 years ago|reply
While somewhat noteworthy, it's not huge (yet). When people talk about yield curve inversion and it being an indicator of recessions, it's much more common to compare the 2-year with the 10-year. Currently that sits at 2.83 (2yr) vs 2.98 (10yr). While the shorter spreads do often invert first, there is no requirement for the longer spreads to follow.
[+] [-] mikhailfranco|7 years ago|reply
Meaning they take short-term deposits (e.g. current account balances) and make long-term loans (e.g. mortgages). They normally make a profit, because they borrow short paying low rates, and lend long receiving high rates. Easy. Head to the golf course.
If the yield curve inverts, banks lose money ... their capital ratios and share prices fall ... they become more risky and less creditworthy ... people withdraw their money ... bank runs, ATMs stop working, bail-ins ... your current account is permanently unavailable (see Cyprus, Greece).
Note that many banks, especially European banks, are starting from an existing almost-bankrupt state, with plummeting share prices (DB, UniCredit, BBVA, BNP). If the EUR yield curve inverts, they all crash faster than an anvil without a parachute (DB is already giving the anvil a good race).
[+] [-] madamelic|7 years ago|reply
And I think the interest rate is inversely proportional to the amount the bonds pay or something like that?
Just explain in simple language. :)
[+] [-] bunderbunder|7 years ago|reply
More generally, a yield curve inversion is when the interest rate you earn on short-term debt ends up higher than that of long-term debt of the same quality.
I don't think the issue is that the inversion causes the recession. It's more an indicator of pessimism in the market. It implies that investors think that interest rates are going to get worse, so they look to buy more longer-term bonds in order to try and lock in current yields for a longer period of time. That increases demand for those assets, which drives down their price^H^H^H^H^H yields.
[+] [-] gibybo|7 years ago|reply
However, when the market expects that maybe interest rates will be falling in the near future (like in a recession), it can prefer to lock in the current rates for a longer term. When markets expect recessions, people tend to buy long term treasuries over short term treasuries which causes the yield of long term treasuries to go down and the yield of short term treasuries to go up.
[+] [-] keeganjw|7 years ago|reply
[+] [-] jstanley|7 years ago|reply
A 5-year bond now has a lower yield than a 3-year bond? How is that even possible? Wouldn't anyone who wants a 5-year bond just buy a 3-year bond and then put the cash under their mattress after 3 years?
Is the idea that in 3 years' time, negative interest rates will be widespread, physical cash will be abolished, and figuratively keeping the cash under your mattress isn't even possible?
EDIT: And why don't arbitrageurs buy up 3-year bonds and sell 5-year bonds?
[+] [-] jameslk|7 years ago|reply
https://stockcharts.com/freecharts/yieldcurve.php
[+] [-] apo|7 years ago|reply
As the same time, the Fed is raising short term interest rates using its tried-and true headline short-term interest rate target.
This is not just unusual - it's unprecedented. QT has the effect of suppressing the yield curve inversion signal (by artificially increasing long-term rates). As a result, the gap between the next yield curve inversion (the one mentioned in the article hardly qualifies) and the next recession could be surprisingly short.
Backing off now on QT and short term raising, with unemployment at a very low point and inflation ramping up, would be lethal to the Fed's credibility. Whatever Powell says to try to talk the stock market up, he's locked and loaded and can't do much beyond stick with the program: triggering the next recession.
[+] [-] Jonanin|7 years ago|reply
[1] https://www.bondbuyer.com/articles/powell-doesnt-see-high-re...
[2] https://www.youtube.com/watch?v=p7Z46p06WS4
[+] [-] Havoc|7 years ago|reply
(Yes yes I know don't time the market)
[+] [-] ep103|7 years ago|reply
[+] [-] neurobashing|7 years ago|reply
[+] [-] jf-|7 years ago|reply
[+] [-] therealdrag0|7 years ago|reply
[+] [-] ep103|7 years ago|reply
[+] [-] jakelarkin|7 years ago|reply
[+] [-] aportnoy|7 years ago|reply
This event reflects the relative preference of the markets for the 5 yrs compared to 3 yrs, producing lower effective yields. This is probably done to secure a certain rate for a longer period of time.
[+] [-] cinquemb|7 years ago|reply
Some banks keep saying 2020 is the big one since that's when most of the corporate debt will be need to rolled over onto higher rates, but I'm of the mind we don't even make it that far because of even shorter term liabilities (think corporate buybacks with debt at higher rates that will increasingly put pressure on balance sheets m/m, liquidity pressure risk assets, devaluation on collateral) in this environment.
[+] [-] jgalt212|7 years ago|reply
[+] [-] NTDF9|7 years ago|reply
I can think of a few explanations for why long term yields are going lower:
1. Long term yields going lower because there are far fewer places for capital to go to besides US treasuries, indicating slower business activity
2. Short term yields going higher because no one wants to buy short-term treasuries because there's something else to invest in or expect higher return for short term investment?
Are these the only two reasons? Why are people so fearful of inverted yield curves?
[+] [-] Tsubasachan|7 years ago|reply
[+] [-] philjohn|7 years ago|reply
[+] [-] howard941|7 years ago|reply
[+] [-] tabtab|7 years ago|reply
[+] [-] shostack|7 years ago|reply
Which raises the question of "isn't every other investor?" And if that's the case, how much of that has the market already factored into pricing?
For example, I hear a lot of people in the Bay Area talking about saving up for when the next crash occurs so they can buy real estate cheap. But if there's sufficient pent up demand and capital, that can dampen the impact like what appears to have happened with the 2008 recession[1], only perhaps magnified after this bull run.
[1] https://www.bayareamarketreports.com/trend/3-recessions-2-bu...
[+] [-] airstrike|7 years ago|reply
[+] [-] FavouriteColour|7 years ago|reply
[+] [-] cm2187|7 years ago|reply
[+] [-] RayVR|7 years ago|reply
[+] [-] ChrisPodlaski|7 years ago|reply
[+] [-] jakelarkin|7 years ago|reply
also true that 2 years a very long time for an economic/investment hypothesis to play out