Over the past two weeks, investors who follow markets on the web or social media may have come across the term, “Inverted Yield Curve”. In this article we will discuss, what yield curve inversion is and what are implications on markets.
Yield curve is a chart showing yields of bonds of different maturities. Yield is the return realized from a bond investment. The normal shape of the yield curve is upward sloping, i.e. short term yields (yields of short term bonds) are lower than long term yields. However, at times the shape of the yield curve gets inverted, i.e. short term yields become higher than long term yields. This is known as yield curve inversion. Yield curve inversion is unusual but it does happen from time to time. On 14th August 2019, the yield of 10 year US Government Bond slipped below the yield of the 2 year US Government Bond. This marked the yield curve inversion that many economists and investment experts are talking about. If you compare the 2 year to 10 year section of our (India’s) yield curve with that of the US, you will observe that the gradients of the two yield curves are exactly the opposite.
Yield curve inversion takes place when the longer term yields falls much faster than short term yields. This happens when there is a surge in demand for long term Government bonds (e.g. 10 year US Treasury bond) compared to short term bonds. As the demand for the longer term bonds increase, the prices of these instruments also increase. Yields have an inverse relation with bond prices – as price increases, yield falls. Also, as investors shift their money to longer term bonds by selling their holdings of shorter term bonds, the price of short term bonds falls and their yields rise. This results in inverted yield curve.
Yield curve inversion caused a huge sell-off in Wall Street (US stock market) around 2 weeks back. Its impact was felt in our market too. Let us understand why the stock market reacts negatively to yield curve inversion. Surge in demand for longer term bonds signals risk aversion. It signifies that investors are worried about economic recession and want to lock-in long term US Government bond yields, which is the safest asset class. Historical 10 year US Government bond yields and GDP data shows that, every recession in the last 40 years or so in the US has been preceded by yield curve inversions. Investors who do not follow the US markets should know that US yield curve has been inverted for quite some time. However, in August 2019 the 10 year bond yield dipped below the 2 year bond yield for the first time since the financial crisis of 2008. This has spooked stock markets around the world.
In an increasingly globalized world, fears of recession in the world’s largest economy, is a cause of concern. However, the economic data coming out of the US is quite strong. US unemployment is the lowest in the last 50 years and the economy is robust. It will also be instructive for investors to note that historically there has been a time-lag between yield curve inversions and onset of recessions; the time-lag between yield curve inversions and recessions ranged from at least a few months to few years. Investors should also know that yield curve inversions have not always led to full-fledged recessions (economic contractions); sometimes it simply led to economic slowdown. The impact of economic slowdown of performance of different asset classes (particularly equity) is less severe than that of recession - recessions tend to last longer than slowdowns and price damage is much more severe in recessions. Recessions have been preceded by slowdowns, but slowdowns have not always led to recessions. Investors should therefore, not panic and act in haste based on rumors and half-baked understanding of the economic situation.