Story Of The Week

U.S. Treasury Yield Curve, Inverted for the First Time since 2007: Should we be concerned?

There has been a lot of speculations and predictions going on about an upcoming recession, but should we really be worried? Is the recession really near?

Well, it’s the ‘INVERTED’ US Treasury Yield Curve which is triggering the first remarkable and reliable signal of an impending recession and a rate cutting cycle. The last time it happened, the world witnessed the global Financial Crisis 2008!

What is a Treasury Yield Curve and how does it indicate about upcoming conditions in an economy?

Source: CNBC

Treasury yield is basically the return on investment, expressed as a percentage, on the Debt Obligation of the any government. Viewed in a different way, the Treasury yield is the interest rate that a nation’s government is paying to borrow money for different lengths of time.

Treasury yields do not just influence how much the government is paying to borrow and how much investors are earning by investing in the particular debt, but also influence the interest rates, that individuals and businesses will have to pay to borrow money to buy real estate, vehicles and equipment. In fact, treasury yields are also an indicator investor’s sentiments about the economy.

The higher the yields of 10-, 20- and 30-year treasuries, the better the economic outlook.

Talking specifically about the United States, whenever the U.S. government needs to raise capital to finance projects such as building new infrastructure, it issues debt instruments through the U.S. Treasury. The different types of debt instruments that the government issues include Treasury bills (T-bills), Treasury notes (T-notes) and Treasury bonds (T-bonds), which come in different years of maturities of up to 30 years. The T-bills are short-term bonds that mature within one year whereas the T-notes have maturity dates of mostly ten years or less. T-bonds, on the other hand, are long-term bonds that offer maturities of 20 and 30 years.

To compensate the investors for the falling demand of treasuries, ‘treasury yield’ increases. Whenever there is low demand, investors are only willing to pay an amount below par value and therefore the price of the bond falls. This increases the yield for the investor since he can purchase the bond at a discount and be repaid the full face value at the maturity date. When Treasury yield is increasing, interest rates in the economy also increase since the government must pay higher interest rates to attract more buyers in future auctions.

Treasury yields can increase if the Federal Reserve increases its target for the federal funds rate (in other words, if it tightens monetary policy), or even if investors merely expect the fed funds rate to increase.

Different Treasury securities have different yields. Under ordinary circumstances, longer-term Treasury securities have a higher yield than shorter-term Treasury securities. Since the maturities on T-bills are short, they typically offer the lowest yield compared to the T-notes and T-bonds. As on November 29, 2017, the Treasury yield on a 3-month T-bill was 1.28%; 10-year note was 2.39% and 30-year bond was 2.82%.

HOWEVER

On Friday, the yield on the 3-month Treasury bill was 2.459 percent while the yield on the 10-year Treasury note was 2.437 percent, according to Refinitiv TradeWeb data. Friday marks the first time since 2007 that spread has been in the negative territory. The 10-year rate finished the week about 16 basis points below where it traded on Monday. The 30-year yield slipped nearly 15 basis points over the same period.

When investors expect a healthy economy, the yield curve slopes upward: Those that agree to take an IOU from the U.S. government for years are compensated with better interest rates than those who loan money for a matter of months. However, its usual upward shape can change when investors think economic output growth is likely to fall.

Source: Bloomberg

When investors expect a healthy economy, the yield curve slopes upward: Those that agree to take an IOU from the U.S. government for years are compensated with better interest rates than those who loan money for a matter of months. However, its usual upward shape can change when investors think economic output growth is likely to fall.

For example, if traders believe Americans will produce fewer goods and services in two years than it will in two months, the curve can invert, or slope downward. The rise of short-term yields above longer-term yields is often viewed as a recession predictor, though technical analysts view inversion of certain sections of the curve as more critical than others.

An upended 3-month to the 10-year curve is widely favored as an indicator that the economy is within a couple of years of recession. And Friday’s move is an extension of the inversion at the front end of the curve that happened in December. The gap between the 2-year and 10-year yields has also narrowed, to around 11 basis points.

“It looks like the global slowdown worries have been confirmed and the market is beginning to price in Fed easing, potential recession down the road,” said Kathy Jones, Chief of fixed-income strategist at Charles Schwab & Co. “It’s clearly a sign that the market is worried about growth and moving into Treasuries from riskier asset classes.”

Some economists argue that technical factors have distorted the curve’s shape and signaling capacity, particularly as crisis-era policy has tethered yields for the past decade. A downturn may be drawing near, after what has been close to the longest expansion on record, however, the market provides no precision on when it will happen.

Theory of Rational Expectations suggests that, ‘people’s current expectations about the economy are themselves, able to influence what the future state of the economy will be.’
Thus, current market sentiment will sooner or later adversely impact the economy, better opt for prevention than cure!

References

https://www.businessinsider.in/yet-another-recession-warning-just-flashed-red-a-treasury-yield-curve-just-inverted-for-the-first-time-since-2007/articleshow/68527618.cms

https://www.nytimes.com/2019/03/22/business/yield-curve-inverted-recession.amp.html

https://in.reuters.com/article/usa-economy-yieldcurve-explainer/explainer-what-is-an-inverted-yield-curve-idINKCN1R32NX

https://www.bloomberg.com/amp/news/articles/2019-03-22/u-s-treasury-yield-curve-inverts-for-first-time-since-2007

 

 

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