Never mind that real interest rates may never become positive in our lifetimes. Yesterday, there was big news that the yield curve has inverted in two places.
This is typically a bad omen of things to come.
Here’s what an inverted yield curve is, and why it’s often bad news for economic expansions…
There has been a lot of talk lately about the inverting of the yield curve, and an inverted yield curve is a big deal, so let’s have a look at it.
First things first, however: what is a yield curve anyway?
A yield curve represents the yield (as in interest) earned on something over different periods of time. Generally speaking, when talking about the yield curve, we are talking about the US bond market specifically. You see, the US sells different types of bonds and shorter term debt bills (all are basically IOUs with some rate of interest). We do this to finance our economy and basically be able to spend the money we don’t have. They are also known in short as “treasuries” and “t-bills”.
Again we pay these various IOUs back with interest (although the yields are much lower than true price inflation).
Then again, we’re talking about the largest financial market in the world.
The types of IOUs the USA sells are:
There are also tied-to-inflation bonds (e.g. TIPs), but that is outside of the scope of this article. As well, the Federal gov’t use rigged inflationary statistics on those supposedly inflation protected IOUs.
People generically refer to all three types of treasuries as “bonds”, but basically, the specific name of each treasury IOU basically refers to the length of the duration of the Treasury or promise to pay.
For example, “T-bills” are a type of treasury that lasts (matures) in less than a year. This can be a 90 day treasury or a one year treasury for example. “Notes” have durations between 2 and 10 years. So the 10-Year Treasury is formally known as the 10-Year Note. “Bonds” have a longer duration than 10 years. Informally, a 30 year bond is called “the long bond”. Generically, people refer to all three types as “bonds”, or the “bond market”.
Here’s the thing to know about the bond market, and it is called, the “time value of money”.
You see, naturally, people value the money they have now than more so than the money they may or may not have in the future.
If I have $20 USD in my wallet, I can spend it whenever and on whatever I want.
But if I loan my somebody $20, and he says he’ll pay me back in a year, well firstly I don’t know if I’m going to be alive in a year. Secondly if he is going to be alive, and we don’t know if he moves, or if I move and can’t collect, or what if inflation is picking up?
With all of those unknowns, I am going to want more than my $20 back, because of the time value of money. Said differently, If I am going to loan out $20, I want to get paid back more than $20 for taking a risk that I might not get paid at all.
So when we are talking about the yield curve, when loaning money to the US government by purchasing treasuries, we have the same risks.
So, if we spend $1,000 on a treasury, we won’t get as much yield on that money if we only loan it out for 90 days than we would for, say, 10 years.
We may be pretty confident we can recoup our money, and it will not have lost out to price inflation in less than 90 days, but how about in 10 years time?
There are many unknowns, so people demand more yield for the risk they take in loaning the money longer term typically.
What about loaning the government money for 30 years? That’s a long time, so the lender, as in the person buying the long bond, is going to want even more yield on the bond.
That is an explanation of the yield curve, and graphically, generically, it looks like this:
Now, that’s not the actual yield curve, but rather, just an example.
You see, according to the chart above, if I loan out my money for a short duration, of, say 3 months, I am getting a yield of a little more than 1.5% on my money. I can be pretty sure I’m not going to die, the borrower isn’t going to default in 3 months, and I won’t lose out to inflation.
But look what happens if I lend my money out for 20 years.
I would be getting 3.0% back on my money because there is much more risk involved in loaning out money for 20 years than there is for 3 months.
So what does the actual inverted yield curve look like?
Well it looks like this:
In the red oval in the yield curve above, we can see the curve has inverted on the 2Y to 5Y spread.
This means that a 2-Year Note is yielding 2.806% while a 5-Year Note is yielding 2.791%.
So we have a partial yield curve inversion, specifically the spreads between the 2Y and 5Y, and also between the 3Y and 5Y.
Note that the rest of the curve is not inverted.
Said differently, if you loan the US government money for 5 years, you will get less back than if you only loaned the money for 2 or 3 years.
Remember the “time value of money”?
The inverted yield curve is in stark contrast of it, which is another way of saying that people value their money now more than they do in the future.
On the chart above, we see that investors are getting paid more to loan for a shorter duration because they would rather just have the money. Since the person buying the bond would rather just have the money, the lender must offer more yield to entice the person (or institution) to actually buy.
OK, well, what does the inverted yield curve mean for the economy?
The short answer is people are concerned about the short-term prospects for the economy.
Remember the talk of “having money on the sidelines”? That is completely applicable here.
Also, the inverted yield curve is a pre-cursor of recession, and that has it’s own implications.
Here’s a graph of interest rates on various USA government IOUs from the Fed’s FRED database:
The gray vertical bars indicate economic recessions we’ve had. They are all acknowledged after that fact by the way.
Now, sure, it looks like a hot mess on the graph, but what we see is that whenever the yield curve inverts, a recession is soon to follow.
Pay specific attention to the BLACK 3-month t-bill line. Often when it pierces the other longer term IOUs in yield, recession gray bars follow shortly there afterwards.
And what does recession mean?
Well, it depends, but it could mean:
- Job losses
- Pay cuts
- Less disposable incomes
- Loss of equity in stocks or in the value of one’s house
- Foreclosures on homes and businesses
- Resetting of market prices based on truer price discovery over debt fueled financial fogs.
- The clearance of various malinvestments and the reapplication of capital into perhaps more economically beneficial pursuits.
Those are just a few examples, but understand the concept – it is natural to want a financial cushion, call it a cash buffer, in economic downturns.
But since the government keeps on spending what it doesn’t have, they must give more in yield in order to get people to take their money out of their savings, or their mattress, and put it into the bond market (specifically here, the USA’s IOU some amount of Federal Reserve note$ over some timeframe market).
So what can we say is going on in the economy right now?
They yield curve is starting to invert, and it already has in two places.
This may indeed mean economic recession is on the horizon, and people are getting concerned about the short-term.
The spread to watch is between the 2Y and 10Y spread. That is the grand-daddy of yield curve inversions, and that is one very bad omen. Granted, an inversion anywhere on the curve is not good and not normal, but when investors demand more in yield over a period of just two years than they would demand over a period of ten years, well, that means there are serious problems in the economy.
So we can circle back to that $20 USD in the hypothetical wallet. People who have $20 to loan (invest) and aren’t concerned about the future can get a rate on the 10 year that is less than somebody who has $20 but is concerned about what might happen in the next six months or so. Perhaps since there is so much short-term uncertainty, that person would rather not lend at all, so he will need to earn a higher yield for that money to come out of savings and into the economy.
Enter the Fed: The Fed has a role in this.
What is the Federal Reserve doing?
The Fed has been, albeit very slowly, raising interest rates since December of 2015.
They are raising the Fed Funds Rate (green line in the FRED chart above), which is basically a form of a very short duration loan made between banks (LIBOR rate for USD).
But here’s the thing – The Fed has raised rates to a range of 2.0% to 2.25%. If they hike again this month the range will be 2.25% to 2.5%.
See how we are getting very, very close to the rates for US Government securities?
Additionally, the US government can’t really handle higher interest rates because the Federal debt is so large, so longer duration interest rates have actually been coming down.
Notice what has been happening to the 10-Year Note even as the fed is hiking:
The yield on the 10-Year Note is back to where it was back in February.
So we have a Fed that is hiking interest rates:
You can see the hikes since the end of 2015.
So that’s a Fed that is hiking overnight lending rates, combined with:
- Interest rates falling on longer duration treasuries (10-Year Note)
- Yield curve inversion between the 2Y – 5Y spread and the 3Y – 5Y spread
The combination of the Fed hiking, longer duration yields falling, and the yield curve inverting are all pointing to an economy that is facing building near-term stresses.
We could already be in recession now, but even if not, with this recent yield curve inversion we can be confident that we will be in an acknowledged economic recession very soon.
– Half Dollar
About the Author
U.S. Army Iraq War Combat Veteran Paul “Half Dollar” Eberhart has an AS in Information Systems and Security from Western Technical College and a BA in Spanish from The University of North Carolina at Chapel Hill. Paul dived into gold & silver in 2009 as a natural progression from the prepper community. He is self-studied in the field of economics, an active amateur trader, and a Silver Bug at heart.