Economists deal with ups and downs in graphs for a living, but when the Yield Curve gets toppled on its head, it causes all the mayhem. Its inversion is the stuff of nightmares for economists and this aversion towards its inversion isn’t without a reason. If we turn our clocks and look back to the past, we can see the flip of the curve has preceded every single recession, notably in the US, for the past half-century or so.
But before we dive deeper into why it is such a big deal for policymakers and investors alike, and how it helps them predict the state of the economy, first let's wrap our heads around what a yield curve is.
First and foremost, the yields in the discussion here are yields from Bonds, more specifically the highest rated Bonds of any country, like the treasury bills in the US or Government bonds in India.
All these bonds offer a fixed coupon payment (Interest) to the holder. However, Yield and Coupon rates are entirely different. While Coupon Rate is applied on the face value of the bonds, Yield is the rate of return an investor gets on the price he paid for such bonds.
For Instance,
Face Value of a Bond- Rs. 1000/ -
Interest Rate- 6% p.a.
Current Market Price- Rs 1200/ -
Yield=Interest/Current Market Price
Yield= 60 /1200=5%
Thus, if the market price decreases, the yield increases, and vice versa, establishing an inverse relationship between the market price of a bond and its yield. For those who stick with the bond till its maturity, this yield won't matter much, but for people who buy and sell bonds at market prices, Yield is a quintessential parameter in deciding whether the bond is worth investing in or not.
Now that we have gone over what Yield means, let’s figure out what yield curve is. When the maturity period of different bonds (say from 3 months to 10 years) are plotted on X- Axis and their corresponding yields are plotted on the Y-axis, we get a ‘yield curve’.
Here is the yield curve of Indian Government bonds, from Overnight Bonds to Bonds with 40- Year Bonds.
The rationale behind this is called 'Liquidity Premium Theory'. Investors who are investing their money for longer periods will obviously demand higher coupon payments and at the same time, are willing to pay a lower price.
These two factors result in a higher yield for long-term bonds, thus giving the yield curve is rising slope.
But when this curve gets inverted, it can get all tipsy-turvy. The inversion is caused when Long Term Yield is lower than the Short term Yield.
This happens when Investors start investing in long-term Bonds resulting in an increase in their prices, which consequents in a decrease in the long-term yield.
This isn’t a good situation for an Economy to be in, because a preference toward long-term bonds indicates that investors don’t have strong confidence in the economy’s short-term prospects and want to secure their long-term payments, at the cost of earning better returns.
And, this preference toward bonds over equity results in a decline in equity investments. As a consequence, economic activities plummet, which ultimately worsens the blow to the economy, as it spirals down toward a gloomy spell of recession.
Make no mistake, the inversion of the yield curve is not the cause of a recession, but it's merely a predictor of it and a very good one at that. Economists all over the globe have long ago recognized it as one of the crucial indicators of economic health, and now that you have apprehended why it is so highly regarded, keep an eye out for the next inversion. It might be closer than you think…Until next time.
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