- Joe Biden Wants to Change 401(k) Plans - November 23, 2020
- Let’s Go Exploring! Boston - November 20, 2020
- How Does a Joe Biden Presidency Affect the FIRE Community? - November 8, 2020
The past few days have been filled with breathless media reports, all of which admittedly sound scary.
“Yield curve inversion: recession sign sparks panic”
Now that one of the most reliable recession indicators in the market got triggered, investors across the globe are starting to worry if this could mean the U.S. economy is slowing down.
That’s because on Friday, March 22, 2019, the US Treasury yield curve inverted. And because the yield curve inverting has historically signalled an upcoming recession, this sent everyone into a panic. The markets dove that same day with the Dow dropping 300+ points.
What is the Yield Curve?
Before we get into this, let’s talk about the yield curve and what it means.
The US treasury issues debt in three basic forms:
- Short-term maturities of less than a year (Treasury bills)
- Medium-term maturities between 1 year and 10 years (notes)
- Long-term 30-year bonds
When you hear news stories about interest rates rising or falling, they’re almost always referring to the federal target rate, a number set by the Federal Reserve, or rather the Federal Open Market Committee (FOMC) which operates under the Federal Reserve system.
This rate has the most direct effect on short-term lending rates. The interest rate on longer-term debt such as notes or bonds is set by the market, meaning that even if the bond is issued with a certain interest rate, if bond traders refuse to buy that bond at that price, then it doesn’t matter. The effective interest rate is determined when someone actually buys it at a certain price, and the lower the price it gets purchased at, the higher the effective interest rate.
To make this a little more concrete, remember that Greek debt crisis that happened a few years ago when it looked like the Greek govenment was going to melt like honey melts into a bowl of delicious delicious Greek yoghurt?
Wait, what was I talking about? Oh yeah, bonds.
Anyway, the Greek government issued bonds back then, but surprise surprise nobody wanted to touch the stupid things. So those bonds only sold at really low, fire-sale prices, which had the effect of spiking the yields on their debt. At the worst of the crisis, investors had so little faith in Greek bonds that they’d only touch them if they were paying a yield of almost 15%!
Anyways, back to the US. Each maturity has its own interest rate. The shorter ones are set by the FOMC, and the longer ones are set by the market. If we were to plot out these interest rates on a chart, it would look like this.
This is a normal Yield Curve. The yield on short term debt is, again, set by the FOMC, and goes up as maturity increases. This makes sense, since it means the bond investor is locking their money away for longer. After all, you wouldn’t buy a 5-year CD or GIC unless it was paying a higher interest rate than a 1-year, right?
Here’s where we are now.
Yikes. What’s going on here? We would say parts of the yield curve have inverted, meaning some longer-term maturities are yielding less than shorter-term ones.
What Does This Mean?
Remember, when it comes to fixed income, yields are inversely proportional to price, and price is a proxy for demand. That means when yields fall, demand for that maturity has spiked which is what led to its price increasing. And when yields spike (like in the Greek situation), that means nobody wants it unless they can pick it up for fire-sale prices.
So what we’re seeing here is a drop in yield and a spike in price (and therefore, demand) in the 3-to-10-year range.
Why did this happen?
In short, the Fed announced on March 20 that not only were they going to not raise interest rates, but they were going to stop raising them for the remainder of the year.
This surprised the Hell out of everyone, because at the beginning of the year everyone was expecting the Fed to continue raising interest rates throughout the year. The big debate was not if, but how many.
So this surprise reaction had an immediate effect in that it caused demand to plop for short term debt and investors to flood into longer term issues.
To investors just learning the ropes, I generally advise they just hold their fixed income assets in a aggregate bond index ETF such as VAB (Canada) or BND (USA) (see our investment workshop for details).
But some investors like to hold their bonds in a short-duration Bond ETF like Vanguard’s VSB. Why? Because when central banks change interest rates, the price of bond ETFs change as well, and you can measure how sensitive a particular bond ETF is to interest rate changes using a metric known as “Duration.”
Remember that bond prices move in the opposite direction as interest rates, so when interest rates go up bond ETF prices go down and vice versa. Exactly how much is given by this “Duration” metric, and how it works is if an ETF’s duration is, say, 5 years, then a 1% interest rate move upwards will cause the bond ETF’s price to go down 5%. Conversely, if interest rates drop by 1%, this bond ETF’s price will go up by 5%.
You can look up any bond ETF’s duration by checking out their prospectus, or more commonly just looking at the fund’s web page. Here’s VAB’s ETF page on Vanguard’s website, and its duration which is currently listed as 7.6.
If you find any of this confusing, don’t worry, you’re not alone. Bonds are a confusing topic. I’m not going to ramble and get lost in the weeds here because I’m trying to make investing LESS confusing, not more! But basically if you think interest rates are going to rise it makes sense to hold your bonds in shorter-duration, shorter-maturity issues because this blunts the negative impact on its price as interest rates rise. VSB, for example, has a duration of just 2.6.
But when interest rates no longer rise? Then it makes no sense for investors to hold short-duration bond ETFs. It makes more sense to dump them in favour of medium-duration ones like VAB, which is the Canadian Bond Index ETF I advocate in our Investment Workshop.
This is what I think happened. Bond traders took one look at the Fed’s announcement and collectively went “Hey, why the Hell am I giving up yield holding short-duration bonds if interest rates aren’t going to rise anymore?” and flooded into medium-term issues, increasing demand and dropping the yield at the 3-to-10-year part of the Yield Curve.
Are We Headed for a Recession?
Now here’s where I have to caution that I’m doing exactly what I’m NOT supposed to do and making a prediction. And also remember that I’m just some blogger and not, say, a former chairman of the Federal Reserve.
But what I honestly think is: No.
You always have to be careful when an indicator like the Yield Curve inverting gets triggered. You have to ask yourself: Why is the indicator being triggered, and does it mean the same thing as in previous situations where a recession did happen?
In most pre-recession yield curve inversions, it’s caused by bond traders flooding into longer term securities because they believe that a rate cut may be on the horizon. Remember, if rates get cut, bond prices will rise, and the bonds with the longer durations are going to rise more than bonds with shorter ones.
So a yield curve inversion is basically the bond market betting on a rate cut, and normally the only reason that rates would get cut is because something horrible is going wrong with the economy.
We’re not in that situation. The Fed didn’t decide to pause their rate increases because the economy is dropping off a cliff. They did it because of political reasons.
For the past year, Trump has been screaming at Federal Reserve chairman Jerome Powell for increasing interest rates. Increasing interest rates, by the way, is exactly what the Fed is supposed to do during economic expansions because it keeps inflation in check, but Trump being Trump was worried that interest rate increases were hurting the stock market, which he’s been using to brag about how great he is. So he’s been threatening to fire Mr. Powell in the news hoping to pressure him into stopping his rate increases.
He’s REALLY not supposed to do that, by the way, since the central bank is supposed to be politically neutral and independent from the rest of the government, but you know, it’s Trump.
So I see the decision by the Fed to halt interest rate hikes as not an economic decision, but rather a political one. And that’s why I don’t think this Yield Curve Inversion means a recession is coming in the US.
Now again, I’m just some blogger and not a former central banker. But in my defence, Janet Yellen, the former central banker, is on my side saying she also doesn’t think a recession is looming either.
But hey, what does she know, right?
What do you think? Is a recession coming? And if so, what are you doing about it?
Hi there. Thanks for stopping by. We use affiliate links to keep this site free, so if you believe in what we're trying to do here, consider supporting us by clicking! Thx ;)
Build a Portfolio Like Ours: Check out our FREE Investment Workshop!
Earn a 1.7%* everyday interest rate. No Everyday Banking Fees.: Open up an EQ Bank Savings Plus Account! (Canada only, excluding Quebec)
LIMITED TIME OFFER: Earn up to 4% cash-back (Canada): With Tangerine's Money-Back Mastercard!
Travel the World: We save $18K a year by using AirBnb. Click here to get $40 off your first booking!
Don't Pay FX fees: We used the Scotiabank Passport Visa Infinite card to eliminate foreign exchange fees around the world! Plus, we got 35k points in the first year, and free airport lounge access too! Click here to sign up!
*Interest is calculated daily on the total closing balance and paid monthly. Rates are per annum and subject to change without notice.