Financial Intelligence Financial Literacy

The Yield Curve is Inverting, Why Is Everyone Afraid?

Mr Life CEO - The Yield Curve is Inverting, Why Is Everyone Afraid

In December 2018, news broke that the yield curve is inverting and it is spooking out investors. Why?

There’s a useful online tool we can use by stockcharts.com called the dynamic yield curve. It plots the yield curve alongside the S&P 500 index for a side-by-side look at yield curve vs market sentiments.

Let’s take a look at the yield curve in Dec 2018.

Yield curve of 7 December 2018. From stockcharts.com

The yield curve is depicted on the left, together with the price of the S&P 500 across time. The red vertical line on the S&P 500 chart indicates the point in time of the index with the corresponding yield curve.

As you can see as of December 2018, the yield curve is flattening. Before we go into what it means, let’s explain the chart on the left.

What is a yield curve?

The yield curve chart plots the respective yields of various U.S. government bonds in the open market. This is the amount of interest you will receive to lend your money to the U.S. government. As you move to the right of the x-axis, the duration of the bonds increases — because the longer you lend out your money, more unexpected things might happen to the economy, and you are more at risk of not getting your money back. Therefore the bond has to compensate you with higher interest.

Typically, bonds with longer duration carry higher yields. Let’s go back to a time before interest rates are so low.

Yield curve of 11 May 1999. From stockcharts.com

Take the chart above as an example. If you were to lend the U.S. government $10,000 for 3 months at 4.65% yield, you will receive your initial $10,000 plus $116.25 in interest (($465 / 12 months) x 3 months) at the end of 3 months. The 3-month bond issued at $10,000 has to pay $38.75 per month for a 4.65% annual yield. The 20-year bond issued at $10,000 will have to have to pay around $600 interest annually (around 6% yield) to compensate for the additional risk. Note that the amount of interest paid by the bonds do not change, and they are issued by the government with a redeemable face value, or principal value of $10,000.

So what does an inverted yield curve mean?

What if you feel that the government might not have the ability to repay your $10,000 principal in 3 months?

Unlikely? Well, let’s assume a “what if”.

Will it be worth risking your $10,000 to buy the 3-month bond just for $116.25 interest? Probably not. How about $9,000? Maybe $8,000? Perhaps $7,000? Regardless, there will come a point for someone, where a principal amount is low enough to be worth risking to earn $116.25 in 3 months.

If nobody buys a bond, the government will lower the principal value but maintain the interest paid to make it more attractive for someone who might be willing to risk… say $7,000 instead of $10,000, to earn an interest of $116.25 at the end of 3 months — the effective yield for the 3-month bond will then work out to be around 6.64%.

And how does such a scenario look like?

Yield curve of 31 August 2000. From stockcharts.com

The yield curve becomes inverted. Short term yields become higher than long-term ones.

This means that bond holders are less willing to risk lending out more of their money to the government in the short-term, although theoretically it shouldn’t be the case. Something is fundamentally wrong and these investors know it.

More people are starting to believe that the U.S. government will be unable to repay its debt in the near future.

How “unlikely” does the scenario seem now?

So were these bond holders correct?

Looking at the grey circle in the chart above, it would seem like it. The S&P 500 tanked 44.75% from its peak at 31st March 2000, just a month after the curve started inverting, to its bottom at 2nd October 2002.

There is another point where the S&P 500 tanked, were the bond holders right during that time?

Yield curve of 27 February 2007. From stockcharts.com

Yep, the yield curve was inverted before the market subsequently crashed 53.36% from its high at 4th October 2007, 15 months after the curve started inverting, to its bottom at 10th March 2009.

Is this of any concern for us?

Yield curve inversion is a sign of losing faith in our debt-based economy, specifically in the U.S. government’s ability to service its short-term debts. However, will this affect us in Singapore?

The following is a chart of the STI index highlighting the same periods when the S&P 500 tanked.

STI Index. From Yahoo! Finance

Looking at the chart, I would say yes. In fact, even more so after the financial crisis of 2007, where the global economy became flooded with trillions of U.S. dollars.

As of now, the yield curve has not yet inverted, but it is flattening. Previously it takes between one to seven months before the curve first inverts after flattening — and the last 2 decades had shown the same outcome once that happens — before the markets crash. Take a look yourself and you will understand why so many people are afraid.

However, this time, things are different. The interest rates have been heavily manipulated by the Federal Reserve since the crash of 2007. More currency has been created and pumped into the system to prop up the market since the crisis, which is the reason why the S&P 500 is in its longest bull run ever.

The free market no longer determines the short-term interest rates because it had been pegged by the Federal Reserve and artificially suppressed since 2007 — which is why the curve is flattening at a much slower pace than before. However, as the Fed inches its interest rates upwards over the last few years as quantitative easing stops, we still see the curve flattening. Long-term interest rates are not catching up. Can the Fed not raise interest rates? No. However, that will be subject for another post.

This time, we might see the same outcome, only that if so, it will be by orders of magnitude that many will not see coming — because the crisis of 2007 was not resolved, only delayed. It is going to hit everyone hard… with interest.

So, for those who have put their faith (and entire life savings) into the stock market thinking that it will only ever go upwards, this is another chance to swallow the red pill, wake up and take steps to protect their wealth.

There might be still time but that window may be closing soon.

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