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You've probably heard about it in the financial press recently: this disturbing and notorious thing called "reversing the yield curve". Should investors be worried about this event? And why are analysts, experts and traders – and even the US president – so obsessed with the reversals of the yield curve, anyway?
A clear review of the nature of the yield curve, its potential impact on equity markets and what it means to you, as a trader, can help you analyze developments in financial news. This understanding can also help you act accordingly – if it's even necessary.
Strange days on the bond market
When you buy a US Treasury bond, you lend your money to the government for a specified period. Or you can look at things differently. The government stores your capital securely in case the stock market and the value of the dollar crumble. Traditionally, the government will reward you for entrusting your money by paying a distribution.
At the time when I was young, the annual yield of a 10 – year Treasury bond was close to 5%. This yield was lower than the average stock market return of 8% per annum, but less risky. (They call bond yields the "risk free rate," after all). Today, annual yields of 5% of 10-year Treasury bonds are totally out of the question. Federal Reserve Chairman Jerome Powell briefly raised the rate to 3% in the fourth quarter of last year. As a result, the stock market had a wheezing crisis. He plunged 20%.
At the time of writing these lines, the ten-year Treasury yield is only 1.528%. The US inflation rate is 1.8%, so the "real" rate (post-inflation) is actually less than zero. It's pretty weird, but it's even weirder. On August 14, the 10-year bond yield was so low that it was exactly the same as the two-year bond yield. This is known as a "flattening of the yield curve" because of the way it is represented on a line chart.
On the same day, the yield curve was "inverted", meaning that the 10-year yield was below the two-year return. This is a very unusual phenomenon since a two-year loan of your money to the government should in principle not pay you more than a ten-year loan. Other yield curves had already been reversed before (including three-month and ten-year returns, if you can imagine). But the gap over ten and two years is the most widely observed.
What does the inversion of the yield curve mean?
Some analysts believe that the reluctance of the bond market to take out a ten-year government loan is a bad sign. This could indicate that they do not trust the government's ability to manage its affairs. In other words, people are looking for borrowing in the short term because they have a long-term pessimistic view of the US economy. It has been said that the bond market is still smarter than the stock market, so a euphoric close to the record high of the S & P 500 and a fearful bond market could indeed indicate future problems. The S & P 500 ETF (SPY) rose nearly 14% year-to-date at Friday's close. At the same time, the iShares 7-10-year Treasury Bond ETF (IEF) has grown by almost 9%.
Knowing that ten-year and two-year rate curve inversions preceded the last two economic recessions, the stock market dipped on August 14, as the S & P 500 (SPY) exchange rate reached 3%. None too happy with this fall, President Trump tweeted, "RETURN YIELD CURVE CRAZY! We should easily reap big profits and gains, but the Fed is stopping us." That day there.
Shortly after, the ten and two year yield curve was not reversed. But then reversed again On August 22 at 4:05 pm (ET), the two-year Treasury yield was 1.614%, while the 10-year Treasury yield was 1.611%. At the time of publication of this article, the yield curve could be inverted, flattened or non-inverted (ie "normal").
A very close call
This is a big part of the market's fascination with the yield curve. It is a very close call at this stage and it is too early to say whether it will remain inverted or not. Some analysts would consider that there remained a negative indicator of market collapse if it remained inverted for months. And, as the Federal Reserve may seek to further reduce yields on 10-year bonds in the near future, early warning signals could flicker sooner than expected.
At the time of writing this article, David Moadel did not hold any positions on the aforementioned securities.
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