Here's a simple example for explaining what this means. Imagine I'm the government, and I sell bonds where I promise I'll pay you back $100 in 5 years or 10 years. Because I'm the government, and I can print money to repay any debt, these bonds are considered very low risk - sometimes they're even called risk free.
The market bids on these bonds, and the market price is public information. Let's say that people are paying $90 for a 5 year bond, meaning they pay $90 today and get $100 in 5 years. Knowing this, we can work out that this is equivalent to a yearly interest rate of 2.13%.
Now we expect that the computed interest rate for the 10 year bond should be higher than the 5 year bond. People want to be compensated for locking up their money for longer. So let's also say people are paying $80 for a 10 year bond, which works out to an interest rate of 2.26%.
These numbers fluctuate up and down every day, and they generally rise and fall with the prevailing interest rates. Here's the key question - what happens if the 10 year interest rate falls below the 5 year rate?
There are a lot of possible reasons, but this often indicates that investors think a recession is around the corner. The reason is that investors are betting that the prevailing interest rates will drop. If interest rates drop, then future bond purchases may have much lower interest rates than those bought today. It turns out you might like the idea of getting 2% interest for 10 years rather than 2.13% for 5 years and then 0.5% for the next 5 years.
Interestingly, the US has never had a recession that wasn't preceded by an inverted yield curve, but not every yield curve inversion has been followed by a recession.
From what you've said, it's my interpretation that if the 10 year interest rate falls below the 5 year interest rate, then it means that bond purchasers speculate that money in 10 years will have more purchasing power than money in 5 years.
I'm actually hoping the fed refuses to lower rates. Let things dip a little rather than try to regulate the economy so much. Them jerking around rates was part of the trigger for 2008. Long term I think rates need to be higher anyway. So here's to hoping the speculators are wrong!
>Because I'm the government, and I can print money to repay any debt, these bonds are considered very low risk - sometimes they're even called risk free.
This is absolutely not the reason they're considered low risk. If the USG tried to repay its debts by printing money, debtholders uninsured against inflation would lose tons of money. The expectation that they're _not_ going to print money to repay debt is part of why it's so safe.
> While the 3-month to 10-year spread “has a relatively decent track record of predicting recessions, it suffers from a timing problem,” said TD Securities U.S. rates strategist Gennadiy Goldberg. “Its inversion can suggest a recession occurred six months ago or will occur two years from now.”
Not just "relatively decent," but perfect over the last seven recessions at least. When the 3-month treasury yields more than the 10-year treasury, the economy has been in recession within two years 7/7 times.
There are a lot of leading economic indicators, but this one beats them all in terms of reliability.
There's one complicating factor that I don't see getting the attention it deserves. Unlike previous cycles, the Fed has been actively manipulating long-term yields for over a decade. That used to be taboo, but not anymore. The Fed holds trillions of dollars of long-term treasuries, accumulated under its QE/X programs.
The ownership of that debt by the Fed puts downward pressure on long-term yields. Recently, the Fed started allowing its long bonds to mature through its "quantitative tightening" (QT) program. That pressure (which really ramped up a few months ago) may have temporarily pumped up yields, and in so doing delayed a yield curve inversion signal. The status going forward of QT and the Fed's gargantuan balance sheet is anybody's guess. My bet is the Fed is done with QT until at least after the 2020 election. If things really start going south, watch for the Fed to begin buying stocks directly like the Bank of Japan has been doing for years. That and negative-yielding treasuries.
Either way, this is unprecedented territory. Signals could be quite confounded for the foreseeable future - which means policy makers are winging it. They almost certainly will make the wrong decisions.
As an investor, I find this rather a good thing. If I have to constantly afraid of recession then I would tend to just wait and sit on cash. If Fed is doing all these interventions including directly buying stock with their trillion dollar war chest + printing press then may be recession can be avoided or at least softened out. I also worry that recession may happen just because people are expecting it to happen even though economy is pretty sound. In that case, Fed intervention can avoid things falling fast just for short time and collective fear can be subsided back to sanity.
> There's one complicating factor that I don't see getting the attention it deserves. Unlike previous cycles, the Fed has been actively manipulating long-term yields for over a decade.
Yeah, very few are talking about what has been going on in the back end by them and how it distorts the curve gymnastics, but even the fed warned last year that it (long end inversion) might not be a reliable signal as it once was (because of their dealings) implying that things may come faster than people may expect if that was what they were only looking at.
The big problem is that people are now starting to realize is that even though QE can provide liquidity, it can't provide solvency: more debt just makes it worse when banks try to lend out their fresh reserves they were able to get from their trade in for liquid assets from the fed, especially if the top line of companies stays the same or starts to deteriorate, even setting aside companies that have been skirting along on negative income for so long because they were able to keep rolling over debt at ZLB.
>The status going forward of QT and the Fed's gargantuan balance sheet is anybody's guess. My bet is the Fed is done with QT until at least after the 2020 election.
QT is still on, just tweaked now:
"
- Begin tapering the “runoff” of Treasury securities in May.
- End the runoff of Treasury securities on September 30.
- Continue shedding mortgage-backed securities (MBS) at the current maximum of $20 billion a month, essentially until they’re gone.
- After September, reinvest MBS principal payments into Treasury securities.
Chair Jerome Powell said during the press conference that the balance sheet will by then be “a bit above $3.5 trillion.”
- The balance sheet will remain at this level even as the economy grows, thus slowly shrinking in relationship to GDP.
- The Fed may sell MBS outright to speed up the process of getting rid of them.
- No decision has been made on the delicate issue of the maturity composition of the balance sheet – which would require buying short-term bills for the first time in years to replace longer-term notes and bonds." [0][1]
>They almost certainly will make the wrong decisions.
Yes they will, and plenty of traders are betting on it. It's amazing that some people think CB's have control of this ship… but hey, someone needs to be on the other side of the trade.
Most of the commentary on the signaling of an inverted yield curve is all parroted by everyone else as “ominous”. Catherine Wood is the only person I’ve seen to go against the grain on this one [0].
Essentially, she notes that the yield curve has been inverted roughly 50% of the time in the late 19th century and early 20th century. Furthermore, during the times it was inverted, it marked periods of strong growth!
It’s an interesting take as everyone else conveniently (more like lazy) are not doing the research and going back as far back as late 18th century. Her point of view is contrarian and refreshingly unique!
> Essentially, she notes that the yield curve has been inverted roughly 50% of the time in the late 19th century and early 20th century.
Actually, she says specifically 1800-1929, which is an interesting choice because AFAICT the “3-month" security (the 13-week T-bill) referenced when discussing the 3m/10y inversion (the one discussed here as a key indicator) was first regularly issued in 1929. [0]
The behavior of the markets when either or both of the instruments in the analysis were not regularly issued is obviously not comparable. (Further, when they aren't both regularly issued, assessing how much of the time an inversion was in effect is, at best, creative extrapolation, and more likely outright fiction.)
> It’s an interesting take as everyone else conveniently (more like lazy) are not doing the research and going back as far back as late 18th century.
So lazy of everyone else to only study a measure as far back as the basic premises of using the measure are valid and the components that make it up actually exist.
A lot of the people in Finance are surprisingly superstitious. I had a boss once who would not conduct trades if he saw a totally unrelated bad omen.
The treasury yield curve is a measure of expectations. It's a market marker that is the result of traders and reflects the overall view of the economy.
Having said that, it's also taken on a mythical status where now that it has inverted, people will start planning for a recession which may in turn lead to happening much sooner/if at all. It's a self fulfilling prophecy in a way where the expectation of a recession leads you act in a way that leads to that outcome.
In December it was the 3 and 5 year which inverted, and today it was the 3 month and 10 year. Typically I’ve understood the biggest one to watch is the 2 and 10 year though.
I'm not sure that the yield curve isn't us being fooled by randomness. Everyone is looking at every metric for predictive ability. The odds that one of them went 7/7 have to approach 1.
I am surprised this is not happening more frequently. An inversion between the 1 and 5 year bonds just means that the expected average yield for each of the next 5 years is less than the yield for next year. Statistically that should be the case 50% of the time. Treasure bonds are liquid, so buying a 5 year one does not mean that you have to hold it to maturity.
There are a few factors that cause one to expect a monotonically increasing, concave yield curve [0].
Firstly, one must consider the term premium [1]. In short, you expect to be compensated more for lending money for a longer period of time. Consider lending money for two years. You could lend your money in two single year-long increments, in which case you would compound your gains from the first year when you lend out the second year. If you lend in a single, two year-long commitment, you rationally expect, all else being equal, to earn as much as you would have by lending as described previously. This drives the general upwards slope (or contango) of the yield curve.
Next, consider a credit component. When you lend someone money, how likely is it that you are paid back? If you expect there is default risk, you factor that into the interest rate you demand. As the tenor of the bond increases, the risk of default increases. However, the extra interest you demand for credit risk also decreases as time goes out. Why? What are the chances that someone defaults on a loan between 5 and 10 years? Probably greater than the risk that the party defaults between 10 and 15 years. This drives the concavity of the yield curve.
Finally, the movement in the curve is driven by expectations of future interest rates, as determined by Federal Reserve policy. Fed typically acts at the short end of the curve. In its tool chest, fed can manipulate rates like the fed funds rate, IOER, and ON REPO. As the economy improves, fed will raise rates. When economic outlook declines, fed will lower rates. If you expect that rates will be higher in the future, you will demand higher yields for longer dated bonds, since your invested money will earn less of a premium to interest rates in the future relative to where you invested today. On the flip side, if you expect interest rates to decline, you will want to lock in your money now, so you purchase longer dated bonds, since you do not expect to be able to get as high a yield in the future. This action at the long end of the curve, coupled with fed policy at the short end, ultimately drives yield curve fluctuations.
>Statistically that should be the case 50% of the time.
Only if the risk premium is the same.
>Treasure bonds are liquid, so buying a 5 year one does not mean that you have to hold it to maturity.
Here you claim that the risk premium is the same because it's liquid. However the term is not the same so you'll be hit with a bigger effect when short term interest rates change on a longer time horizon instrument.
Where are you getting this 50% from? Also, you're ignoring that there is more price risk in long bonds even if you can sell them, so there should anyway be a term premium (upward-sloping curve) even if the expected interest rate over five years is constant.
Hmm for some reason I thought this was already the case actually.
I was looking at Ally CD rates a few weeks ago, and I saw an inversion there and I just chalked that up to the CD rates being dependent on the yield curve.
There was a less extreme yield curve inversion a few months ago, which is likely what you're referring to. But it wasn't so far reaching as the current inversion, which puts the 1 year Treasury over the 10 year.
Lending money for longer term is disadvantaged vs. shorter term so borrowing is impacted. This leads to less stability and in the past has been a fairly good indicator of an upcoming recession.
Past performance is not an indicator of future returns.
When investors buy bonds, specifically US Treasury securities, the relationship between the yield and the time to maturity (2,3,5,7,10,30 years) is generally upward sloping because, as the logic goes, the longer dated securities should have a higher yield because the investor wants to get paid more since they are parting with their money for longer.
When we see yield curve inversions, usually beginning with just a small 'kink' on some point in the curve, that means that the yield at a point further out is lower than a shorter dated security. When the yield curve inverts like this, it means that demand for shorter-dated bonds is higher than longer-dated bonds, and because the duration of longer-dated bonds is higher than shorter-dated bonds, when demand falls for longer-dated bonds, those investors will instead buy shorter-dated bonds. Can also mean that the market believes that a recession is coming, so there's a flight to safety out of equities and into shorter-dated treasuries.
[+] [-] spchampion2|7 years ago|reply
The market bids on these bonds, and the market price is public information. Let's say that people are paying $90 for a 5 year bond, meaning they pay $90 today and get $100 in 5 years. Knowing this, we can work out that this is equivalent to a yearly interest rate of 2.13%.
Now we expect that the computed interest rate for the 10 year bond should be higher than the 5 year bond. People want to be compensated for locking up their money for longer. So let's also say people are paying $80 for a 10 year bond, which works out to an interest rate of 2.26%.
These numbers fluctuate up and down every day, and they generally rise and fall with the prevailing interest rates. Here's the key question - what happens if the 10 year interest rate falls below the 5 year rate?
There are a lot of possible reasons, but this often indicates that investors think a recession is around the corner. The reason is that investors are betting that the prevailing interest rates will drop. If interest rates drop, then future bond purchases may have much lower interest rates than those bought today. It turns out you might like the idea of getting 2% interest for 10 years rather than 2.13% for 5 years and then 0.5% for the next 5 years.
[+] [-] WillPostForFood|7 years ago|reply
[+] [-] posix_compliant|7 years ago|reply
Is that interpretation correct?
[+] [-] phkahler|7 years ago|reply
[+] [-] lisper|7 years ago|reply
They may be called that, but they aren't. There are at least two risks associated with U.S. government bonds:
1. Inflation can exceed the interest rate on the bond and cause it to lose value when measured in actual purchasing power
2. Political dysfunction could cause the U.S. government to default notwithstanding its ability to print money
(To be fair, #1 is a risk associated with any bond. #2 is peculiar to U.S. government bonds.)
[+] [-] listenallyall|7 years ago|reply
This was not simple, nor did you explain what this means
[+] [-] bobcostas55|7 years ago|reply
This is absolutely not the reason they're considered low risk. If the USG tried to repay its debts by printing money, debtholders uninsured against inflation would lose tons of money. The expectation that they're _not_ going to print money to repay debt is part of why it's so safe.
[+] [-] apo|7 years ago|reply
Not just "relatively decent," but perfect over the last seven recessions at least. When the 3-month treasury yields more than the 10-year treasury, the economy has been in recession within two years 7/7 times.
https://seekingalpha.com/article/4250287-fully-inverted-yiel...
There are a lot of leading economic indicators, but this one beats them all in terms of reliability.
There's one complicating factor that I don't see getting the attention it deserves. Unlike previous cycles, the Fed has been actively manipulating long-term yields for over a decade. That used to be taboo, but not anymore. The Fed holds trillions of dollars of long-term treasuries, accumulated under its QE/X programs.
The ownership of that debt by the Fed puts downward pressure on long-term yields. Recently, the Fed started allowing its long bonds to mature through its "quantitative tightening" (QT) program. That pressure (which really ramped up a few months ago) may have temporarily pumped up yields, and in so doing delayed a yield curve inversion signal. The status going forward of QT and the Fed's gargantuan balance sheet is anybody's guess. My bet is the Fed is done with QT until at least after the 2020 election. If things really start going south, watch for the Fed to begin buying stocks directly like the Bank of Japan has been doing for years. That and negative-yielding treasuries.
Either way, this is unprecedented territory. Signals could be quite confounded for the foreseeable future - which means policy makers are winging it. They almost certainly will make the wrong decisions.
[+] [-] sytelus|7 years ago|reply
[+] [-] cinquemb|7 years ago|reply
Yeah, very few are talking about what has been going on in the back end by them and how it distorts the curve gymnastics, but even the fed warned last year that it (long end inversion) might not be a reliable signal as it once was (because of their dealings) implying that things may come faster than people may expect if that was what they were only looking at.
The big problem is that people are now starting to realize is that even though QE can provide liquidity, it can't provide solvency: more debt just makes it worse when banks try to lend out their fresh reserves they were able to get from their trade in for liquid assets from the fed, especially if the top line of companies stays the same or starts to deteriorate, even setting aside companies that have been skirting along on negative income for so long because they were able to keep rolling over debt at ZLB.
>The status going forward of QT and the Fed's gargantuan balance sheet is anybody's guess. My bet is the Fed is done with QT until at least after the 2020 election.
QT is still on, just tweaked now:
" - Begin tapering the “runoff” of Treasury securities in May.
- End the runoff of Treasury securities on September 30.
- Continue shedding mortgage-backed securities (MBS) at the current maximum of $20 billion a month, essentially until they’re gone.
- After September, reinvest MBS principal payments into Treasury securities. Chair Jerome Powell said during the press conference that the balance sheet will by then be “a bit above $3.5 trillion.”
- The balance sheet will remain at this level even as the economy grows, thus slowly shrinking in relationship to GDP.
- The Fed may sell MBS outright to speed up the process of getting rid of them.
- No decision has been made on the delicate issue of the maturity composition of the balance sheet – which would require buying short-term bills for the first time in years to replace longer-term notes and bonds." [0][1]
>They almost certainly will make the wrong decisions.
Yes they will, and plenty of traders are betting on it. It's amazing that some people think CB's have control of this ship… but hey, someone needs to be on the other side of the trade.
[0] https://wolfstreet.com/2019/03/20/feds-new-balance-sheet-pla...
[1] https://www.federalreserve.gov/newsevents/pressreleases/mone...
[+] [-] whb07|7 years ago|reply
Essentially, she notes that the yield curve has been inverted roughly 50% of the time in the late 19th century and early 20th century. Furthermore, during the times it was inverted, it marked periods of strong growth!
It’s an interesting take as everyone else conveniently (more like lazy) are not doing the research and going back as far back as late 18th century. Her point of view is contrarian and refreshingly unique!
[0] https://www.cnbc.com/2018/12/04/the-economy-will-surprise-to...
[+] [-] dragonwriter|7 years ago|reply
Actually, she says specifically 1800-1929, which is an interesting choice because AFAICT the “3-month" security (the 13-week T-bill) referenced when discussing the 3m/10y inversion (the one discussed here as a key indicator) was first regularly issued in 1929. [0]
The behavior of the markets when either or both of the instruments in the analysis were not regularly issued is obviously not comparable. (Further, when they aren't both regularly issued, assessing how much of the time an inversion was in effect is, at best, creative extrapolation, and more likely outright fiction.)
> It’s an interesting take as everyone else conveniently (more like lazy) are not doing the research and going back as far back as late 18th century.
So lazy of everyone else to only study a measure as far back as the basic premises of using the measure are valid and the components that make it up actually exist.
[0] https://www.treasurydirect.gov/indiv/research/history/histmk...
[+] [-] unknown|7 years ago|reply
[deleted]
[+] [-] potatofarmer45|7 years ago|reply
The treasury yield curve is a measure of expectations. It's a market marker that is the result of traders and reflects the overall view of the economy.
Having said that, it's also taken on a mythical status where now that it has inverted, people will start planning for a recession which may in turn lead to happening much sooner/if at all. It's a self fulfilling prophecy in a way where the expectation of a recession leads you act in a way that leads to that outcome.
[+] [-] Invictus0|7 years ago|reply
[+] [-] tehlike|7 years ago|reply
[+] [-] wk0|7 years ago|reply
https://fred.stlouisfed.org/series/T10Y2Y
[+] [-] nodesocket|7 years ago|reply
[+] [-] mattmaroon|7 years ago|reply
[+] [-] all_blue_chucks|7 years ago|reply
[+] [-] buzzdenver|7 years ago|reply
Somebody tell me where I'm wrong.
[+] [-] nickles|7 years ago|reply
Firstly, one must consider the term premium [1]. In short, you expect to be compensated more for lending money for a longer period of time. Consider lending money for two years. You could lend your money in two single year-long increments, in which case you would compound your gains from the first year when you lend out the second year. If you lend in a single, two year-long commitment, you rationally expect, all else being equal, to earn as much as you would have by lending as described previously. This drives the general upwards slope (or contango) of the yield curve.
Next, consider a credit component. When you lend someone money, how likely is it that you are paid back? If you expect there is default risk, you factor that into the interest rate you demand. As the tenor of the bond increases, the risk of default increases. However, the extra interest you demand for credit risk also decreases as time goes out. Why? What are the chances that someone defaults on a loan between 5 and 10 years? Probably greater than the risk that the party defaults between 10 and 15 years. This drives the concavity of the yield curve.
Finally, the movement in the curve is driven by expectations of future interest rates, as determined by Federal Reserve policy. Fed typically acts at the short end of the curve. In its tool chest, fed can manipulate rates like the fed funds rate, IOER, and ON REPO. As the economy improves, fed will raise rates. When economic outlook declines, fed will lower rates. If you expect that rates will be higher in the future, you will demand higher yields for longer dated bonds, since your invested money will earn less of a premium to interest rates in the future relative to where you invested today. On the flip side, if you expect interest rates to decline, you will want to lock in your money now, so you purchase longer dated bonds, since you do not expect to be able to get as high a yield in the future. This action at the long end of the curve, coupled with fed policy at the short end, ultimately drives yield curve fluctuations.
[0] https://obliviousinvestor.com/wp-content/uploads/2012/07/yie...
[1] https://www.bloomberg.com/news/articles/2017-10-30/what-s-a-...
[+] [-] sf_rob|7 years ago|reply
Only if the risk premium is the same.
>Treasure bonds are liquid, so buying a 5 year one does not mean that you have to hold it to maturity.
Here you claim that the risk premium is the same because it's liquid. However the term is not the same so you'll be hit with a bigger effect when short term interest rates change on a longer time horizon instrument.
[+] [-] pishpash|7 years ago|reply
[+] [-] aznpwnzor|7 years ago|reply
I was looking at Ally CD rates a few weeks ago, and I saw an inversion there and I just chalked that up to the CD rates being dependent on the yield curve.
Does it?
[+] [-] levthedev|7 years ago|reply
[+] [-] Varcht|7 years ago|reply
[+] [-] unknown|7 years ago|reply
[deleted]
[+] [-] ckdarby|7 years ago|reply
[+] [-] alanbernstein|7 years ago|reply
> Inversion is considered a reliable harbinger of recession in the U.S., within roughly the next 18 months.
[+] [-] defertoreptar|7 years ago|reply
[+] [-] maroonedanchor|7 years ago|reply
Past performance is not an indicator of future returns.
[+] [-] arthurcolle|7 years ago|reply
https://en.wikipedia.org/wiki/Yield_curve#/media/File:Yield_...
something like that is usually "what's expected".
When we see yield curve inversions, usually beginning with just a small 'kink' on some point in the curve, that means that the yield at a point further out is lower than a shorter dated security. When the yield curve inverts like this, it means that demand for shorter-dated bonds is higher than longer-dated bonds, and because the duration of longer-dated bonds is higher than shorter-dated bonds, when demand falls for longer-dated bonds, those investors will instead buy shorter-dated bonds. Can also mean that the market believes that a recession is coming, so there's a flight to safety out of equities and into shorter-dated treasuries.
That's the gist of it