The yield curve has inverted!

So what’s next? Why does this even matter? Where do I go from here?

What’s the Yield Curve?

The yield curve is simply https://www.marketwatch.com/story/the-yield-curve-inverted-here-are-5-things-investors-need-to-know-2019-03-22a two-dimensional chart showing the relationship between the yields paid (on the Y-axis) on bonds of different maturities (on the X-axis). The bonds here are U.S. government securities and hence, the only difference is the length of the maturity (i.e. how long investors have to keep their money invested in the bond until maturity)

By Ldecola – Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=69078386

So what you can see is that for bonds with longer maturities, the yield paid is higher. For example, a 2-year bond might pay 2.5% p.a. while a 10-year bond pays 3% p.a.

In a normal world, this makes sense. After all, to entice investors to keep their money invested in a bond for a longer period, borrowers need to pay more interest.

Why Does the Yield Curve Invert?

That’s all good and fine but if that’s the case, then why does the yield curve invert? Well, as it turns out, if you hold a bond (which is an asset) but you need cash, you can always sell the bond on the secondary market. However, you’ll will have to accept whatever the market is willing to pay for your bond.

Let’s work through an example.

So, the way bonds work is that bonds pay investors a coupon (i.e. the interest) based on the Face Value of the bond. This Face Value is the principal amount that the investor receives upon the maturity of the bond. So for example, if a bond pays a coupon of 5% on a bond with maturity of 5 years and a face value of 100, then the investor receives $5/year for 5 years and $100 at the end of the fifth year.

So far so good?

However, if you have to sell the bond on the secondary market before it matures, the price that buyers are willing to pay may be less than the face value. This happens because would-be bond investors are weighing their other options given the environment at the time you, the bond seller, are trying to sell your bonds.

If there are more attractive investments out there or there is pessimism in the air, would-be buyers would offer a lower price for your bonds and vice versa if things seem to go swimmingly well.

So using the same example of a bond as above. If the market is willing to pay only $80 for your bond, the yield on this bond is now $5/80 which is 6.25% which is higher than the coupon yield.

This is exactly how and why yields change.

So, what is the inversion? And why it matters

An inversion happens when short-term yields are higher than long-term yields.

The short end of the curve is easy to explain because the Fed rate hikes have most influence on short-term rates and given the fact that the Fed has been raising rates since late 2015 and somewhat accelerated the hikes last year, the short end of the curve must have increased.

But what about the longer-term rates? Going by the logic in the previous section, this means that prices of bonds at the long end are much higher which is why yields at the long end have fallen.

This basically means that bond investors don’t mind getting less return for longer maturities since they expect things to get worse in the short-term and therefore, it’s a good return to “lock in” for the next X number of years. Furthermore, if a recession hits, the Fed will be forced to lower rates to ease monetary policy and when interest rates fall, bonds at the long end see greater capital gains as their Duration is longer*

The inverted yield curve has also freaked people out because the inversion of the yield curve has historically been a good leading indicator of recessions.

Final Thoughts

So while a recession may be imminent, I think we need to keep an eye on other indicators such as unemployment and payroll numbers etc. Singapore will obviously be hit bad in the event of a global recession since we count many of the major economies as our trading partners.

However, I think a recession and slowdown has been long overdue and maybe markets have already priced the worst in (or maybe, they haven’t) but we haven’t seen over-extended markets or exuberance like we have in the dot-com or GFC eras.

Personally, I’ve been on the defensive for some years and if the downturn comes, I’ll be one happy camper because it’s probably one of those moments that I’ll be able to deploy some cash.

Notes:
*Duration is a finance thing. Basically, it shows how many percent a bond price will change for a one percent change in interest rates.

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