How the yield curve affects the economy

2022.04.01 00:08

How the yield curve affects the economy

Budrigannews.com – The “primary market” yields of various government bonds and notes are depicted on the yield curve. There are approximately $120 trillion in outstanding obligations on the global bond market, which includes both private and public debt. 39 percent of the total is owned by the United States.

Taxes are collected and debt is issued by the United States government to fund spending. More specifically, debt instruments with varying maturities are issued by the United States Treasury to fund deficit spending. 

The maturities of Treasury Bills range from one month to one year.
The duration of a Treasury Note ranges from two to ten years.
Treasury Bonds with maturities of between 20 and 30 years are issued for very long-term debt. 

Over a variety of timeframes, demand and economic expectations influence Treasury yields. In a “primary market” auction process where prices and yields are inversely correlated, competitive bidders set yields. Keep in mind that participants in the market, not the Federal Reserve of the United States Fed), establish these yields and prices. A discount rate and a very short-term (overnight) Fed Funds Rate are set by the Fed. The process of debt auctioning is not directly under their control, but their policy of lowering or raising those rates has significant influence.

A plot of the United States yield curve features both a normal and an inverted curve. The “normal” curve with longer-term debt yielding more than shorter-term debt is depicted by the red line. The blue line depicts an inverted curve in which debt with shorter terms yields more than debt with longer terms. That reflects the expectation of a higher yield due to the belief that inflation will reduce returns over time. 

Why is the curve reversing?

Typically, the yield curve is referred to as steepening, flattening, or inverting.

A steep curve indicates expectations of higher interest rates and inflation as a result of a stronger economy.

When Fed policy is in a tightening cycle that involves raising rates in the near future, the curve typically flattens or even inverts. This suggests that investors have less faith in the long-term economic outlook and anticipate that the Federal Reserve will need to cut rates to boost the economy at some point in the future.

What Is the Meaning of an Inverted Curve?

Every US recession in the past 60 years has been preceded by at least a partial inversion of the yield curve. That delay has taken an average of 22 months and ranged from six to 36 months.

However, a recession has not followed each yield curve inversion. An inverted yield curve suggests, but does not guarantee, a recession as a predictor. 

Keep in mind that a recession technically occurs when GDP growth is negative for two consecutive quarters. Economic slowdowns that aren’t quite as severe as a full-blown recession are definitely possible. 

It might be more accurate to say that an inverted yield curve is a fairly accurate indicator of a slowdown in the economy but not necessarily a recession.

Is this time different?

Maybe. In an unusual move, the Federal Reserve has used “Quantitative Easing” over the past two years to help the economy recover from the COVID Crash in March 2020. By purchasing bonds with longer maturities, the Fed has been expanding its balance sheet. The Federal Reserve has announced that it will shift to selling bonds to reduce its balance sheet as the economy has improved. 

Many observers believe that the Fed’s action has artificially maintained low long-term yields, particularly the 10-year, and that those yields will likely rebound once the Fed stops selling its excess. The yield curve might suddenly become steeper if that were to occur.

Additionally, it is up for debate which segments of the yield curve to compare. The “2/10” (comparison of 2-year and 10-year yields) has traditionally served as a popular standard. Comparing 3-month and 10-year yields, according to some observers, is a better indicator. Additionally, there is a greater degree of uncertainty regarding an imminent recession if there is not an inversion within the next three months or one year.

What Effect Does This Have on Stocks?

It is without a doubt a fascinating discussion and a possible indicator of a slowdown in the economy, if not a recession. However, it is only one piece in a much larger puzzle. We shouldn’t rely solely on the discussion of the yield curve when making investments. 

Technical indicators of stock price action and stock index valuations are more important to me as a trader and investor. Even during a recession, some industries perform better than others. Money moves all the time. The ball I’m keeping an eye on is that one.