When you go to your bank to start an FD, do you remember how fixed deposit interest rates vary for different periods?
Why does this happen? Well, think about it for a second.
The answer lies in the most fundamental term of banking – net interest margin!
Net interest margin is the difference between rates at which banks borrow and lend. If a bank were to borrow money from you at x%, to make a profit or margin, they need to lend the money to a third party at an interest rate of more than x%. If it can’t, it will be unable to make a profit.
Let’s bring in another aspect now – tenure of the loan!
Imagine loaning an amount to someone. Would you be more comfortable loaning the person for 1 month or loaning the person for 5 years? 1 month, of course! In 5 years, who knows what will happen!
So, lending money for a shorter period of time is less risky and hence the lender can charge only a lower interest rate.
For now, the reader should remember two things and their significance –
- Banks make profit by lending at a higher rate than they borrow
- The interest rates on shorter loans are less than on longer loans (borrower perspective)
The following graph should give the reader a directional sense of how a lender will lend –This graph is very important to our discussion.
One final pointer the reader should know about banking is how do banks make profit.
Yes, banks borrow at x% and lend at y%. If y is greater than x, the difference is the bank’s profit.
But why should y be greater than x?
Because banks borrow for the short term and lend for the long term.
This is the most basic idea behind banking. If a bank is going to borrow for 5 years (let’s say you start a 5-year FD) and lend to your friend for 5 years, there is hardly any room for profit!
Again, as someone who uses the bank to save and borrow, think about the tenures of your deposits and your loans.
- Deposits include your savings bank account, RDs and FDs. Most of these are really short term. So, as a lender you don’t get high interest rates. This is because, by lending to the bank for the short-term you are not taking on as much risk.
- Loans include car loans and home loans with tenures way longer than your deposits. The interest rates on these are higher since longer term loans are riskier from the bank’s perspective.
For the normal functioning of banks, it is vital that the above graph holds. If it doesn’t banks can’t function. Credit will come to a standstill and the economic gears will stop rotating! Yes, that’s how serious this is!
We’ve established a great foundation to understand the yield curve and then the yield curve inversion, in particular. So stick around!
The Yield Curve
Simply said, the yield curve plots the returns you earn on the same bond across time frames.
The yield curve is influenced primarily by two factors –
- The policy rate set by the central bank (Federal Reserve in the USA and RBI in India)
- The bond market (there’s an auction market for bonds like there is for equities!)
The central banks are able influence the shorter bond yields more than longer bond yields. The bond market is the place where longer bond yields are mainly determined.
For most parts, the yield curve looks very similar to the graph above. Here it is again –We call this a ‘normal’ yield curve.
The yield curve of government securities is the most important input for banks to set interest rates on lending and borrowing. Steepness of the yield is curve is also significant.
However, banks do consider other inputs. But these are not relevant to the yield curve inversion discussion.
The Flat Yield Curve
What happens when you push the right end of the normal yield curve down?
You approach a flat yield curve as you can see below –A flag yield curve means the yields on all maturities are roughly the same. You buy a 6 month government bond or a 5 year government bond, it doesn’t matter. The interest rate on both will be practically the same!
However, this is not a desired situation. Banks will not be able to profit and hence become reluctant to lend. This will slow down the economy.
Let’s see why the yield curve might flatten. There are two scenarios that can bring about the flattening of the yield curve –
- The short term rates shoot up
- The long term rates go down
The short term rates, as you may remember, are influence by the central banks. If they raise rates too quickly and the long term rates don’t move, we could get a flat curve.
The long term rates, as you may remember, are influenced by the bond market. If they suddenly start demanding for long term bonds, that will bring the yield down.
Why could there be a sudden demand for long term bonds?
Lending to the government is the safest deal one can make (we’re talking about the USA govt here; in most economically weak countries, lending to the government is actually quite risky!)
When do you make a safe deal? Generally, when you are scared of making a risky deal.
When investors start losing confidence in the market or the economic conditions, they generally flee from risky assets like equity. Where do they invest them? You’re right – government bonds!
When conditions are rough, the demand for government bonds shoots up! And when one is scared, one makes the safest bet – the longest government bonds!
Moral of the story: Uncertain times call for safety. Long term government bonds are the safest instruments and their demand surges during uncertain economic conditions which lowers their yield.
The Yield Curve Inversion
Now that we know how a yield curve flattens, it is really easy to understand why it may invert.
An inverted yield curve looks like the following –Suppose that the demand for long term bonds really shoots up. We will then reach a point where the flat yield curve will invert.
When the yield curve inverts, the short term rates are considerably higher than the long term rates! This is unusual, bizarre and undesirable!
- Unusual because this is not how the system is meant to be. Under normal conditions, only the ‘normal’ yield curve should persist.
- Bizarre from the perspective of the banks. If they continue operations basis an inverted yield curve, do you think they will borrow at a higher rate and lend at a lower rate?
- Undesirable because the answer to the question pose above is a resounding NO! The economy works and keeps moving because banks and other institutions lend. The moment banks become reluctant to lend money the economy slows down.
We now clearly see why inverted yield curve is a problem. But how does one get back to the normal yield curve?
Remember that central banks influence the short term interest rates. If they see that the short term interest rates are higher than the long term interest rates, they can step in. And they do!
Central banks will quickly step in and normalize the yield curve by lowering the short term interest rates thereby restoring normal conditions. But this may take some time and during this time the yield curve may stay inverted.
Inverted Yield Curve: A Recession Predictor?
The meat of the topic!
Now that you know what an inverted yield curve is, the logical question arises – As an investor, why should you care?
Well, you certainly must. Because an inverted yield curve is generally a sign of low confidence among investors. If the market believes in something, very often it is right!
Wait! Aren’t we talking of the USA yield curve and its inversion? Yes, we are!
I invest in the Indian markets, man. You’ve simply wasted my time! No, we haven’t!
We live in a well-connected world. If the USA sneezes, the rest of the world catches cold.
Think about 2008. The Indian economy was perfectly fine. But the sub-prime loan crisis in the USA had such far-reaching effects that Indian equities were down by 50% or more!
So, yes, even as an Indian market investor, you must care about the global scenario. Especially, the USA.
Here’s an interesting graph –As you can see, recessions (shaded area) and yield curve inversions (blue line going below 0) appear almost next to each other.
A fair statement to make would be ‘A sustained yield curve inversion is a precursor of a recession.’ Emphasis on sustained.
But nothing can be said of the time between a sustained yield curve inversion and the following recession. The average time between a yield curve inversion and a recession is around 15 months, however.
That means a yield curve inversion gives you time to exit from the markets if you want to protect your money. But wait, what happens in those 15 months is something that one should not overlook!
Every time the yield curve has inverted the market has rallied! Yes, you read it right. Instead of resorting to safety after such a strong indicator shows up, the market actually bid higher and higher for stocks!
This has been observed historically time and again and can put anyone into a great predicament.
If someone has Rs. 100 invested in the market and knows that some time in the next 2 years, that Rs. 100 faces the danger of becoming Rs. 50, but during those two years, it is also very likely that the Rs. 100 becomes Rs. 125 or even Rs. 150, what do you expect? Difficult question, huh?
But you said sustained yield curve inversions have preceded recessions, no? The one we are talking about lasted for more than 5 months; so, it qualifies as a sustained inversion.
So, what does the most recent yield curve inversion should mean to you as an investor?
The most recent yield curve inversion was observed in 2019. The yield of 3-month treasury bills exceeding that of 10-year treasury bonds in May 2019.
The yield of 3-month treasury bills was greater than the 10-year treasury bonds for about 5 months until October 2019. This is highlighted in the following chart –
What happened next is not surprising. The Federal Reserve stepped in and started cutting rates. This had two effects –
- The yield gap between 3-month bills and 10-year bonds lessened since Federal Reserve’s influence started decreasing 3-month yields
- The market gained some confidence which it had lost and investors started flocking back to riskier assets like stocks – this reduced the demand and increase the yield of 10-year bonds
Now, what should you do about this with regards to your investments?
First of all, a yield curve inversion should alert you. We have been in the longest expansion in history, economy has been weak for quite some time and a yield curve inversion in the midst of all this is just something that should alert you.
Secondly, you should think of either getting out or staying in or even investing more!
Thanks for reading!
PS – At Finpeg, we use the yield curve along with a multitude of indicators to guide our investors’ money in and out of bonds and equity. You can have a look at our offerings here.
Also published on Medium.