What is the yield curve? Why is this important? What does it mean?
US Treasury yields reversed; it was all over the news, but why? A yield curve represents the yields of fixed income instruments over various maturities. It plots the yield of issued Treasury securities. Treasury securities are bonds or treasury bills issued by the government to raise funds.
The government can borrow for 91 days by issuing securities called treasury bills. The government can also borrow for more than 12 months by issuing bonds. Securities such as bonds pay a coupon, representing the fees or compensation earned by the lender of cash to the government. Yield is the return from owning that security; the coupon paid is divided by the price of the security. So a two-year FG bond that costs N100 and pays a coupon of 5% will yield 0.5% (5/100).
A yield curve like diagram 1 below will plot the duration of the issued security on the horizontal axis. Thus, we see tenors from zero to twenty years old. The Y axis measured percentage return from 2% to 14%.
Chart 1: The Nigerian Yield Curve March 2022
The yield curve maps the relationship between duration and returns earned. The general rule is simple; the unexpected volatility if you lend money for one year is less than the five-year unexpected volatility. This means that you, the lender, must demand a higher interest rate from the borrower, in this case a higher coupon payment.
A normal yield curve will therefore look like a rising curve. See Figure 21. Indicates that the yield on a two-year bond is lower than the interest rates paid on the yield on a five-year bond. In an economy, if borrowers are optimistic about their economic prospects, they will borrow to invest in capital projects and expand their operations. This demand for longer-term funds to invest leads to higher interest rates charged by lenders; thus, the curve steepens as rates rise on longer-dated instruments.
However, the opposite happens when investors have doubts about the economic future. Perhaps a covid 19 infection will cripple trade and commerce, leading businesses to cut back on investment and spending. This drop in spending translates into less demand for credit to expand operations; this drop in demand for credit will lower interest rates, especially longer-term interest rates. Thus, the graph will gradually become flat, which means that the short-term rates are at the same level as the long-term rates. A flat curve is also an inflection point. Economic activity may pick up and rates start to rise again, steepening the yield curve again, or economic activity falls.
From a fixed rate position, if the outlook for economic activity becomes more pessimistic, investors will completely abandon borrowing to invest. This expectation of lower interest rates over the longer term is therefore reflected in the yield on longer-term bonds, such as the ten-year being lower than the yield on the shorter-term 2-year bonds.
A reversal is therefore abnormal and signals to the market that economic activity will decline. Remember that correlation is not causation. The yield curve itself does not cause a recession, but in the United States an inverted curve has preceded the last eight recessions since 1969 and the yield curve has inverted before each recession for the past fifty years. If we take the United States today as an example, the yield of the benchmark 10-year note fell below that of the two-year note on Tuesday 29 2022; this is in an environment where the Federal Reserve is raising rates in the economy, but the US economy is still looking for workers to fill vacancies estimated at 5 million more than the number of US workers looking a job. High jobs and recessions don’t mix. Still, an inversion indicates weaker growth ahead.
If there is no correlation between yield curves and recession, why is this an important event to note? A reversal is an early warning indicator that the economy sees trouble ahead. It also means that businesses will see their short-term borrowing costs for working capital rise as short-term rates rise. These additional costs weigh on consumption and, ultimately, on economic activity, which is never good. In addition, intermediary lenders who borrow and lend will see their margins reduced.
For borrowers, the cost of credit on credit cards and car loans will increase. it is good advice to repay open lines of credit, especially shorter lines and to check that all adjustable rate instruments can be refinanced, meaning that you take out a new loan to repay over a longer fixed term .
What to invest during an inversion?
During an invasion of the yield curve, the key word is quality and duration. Since long term risky assets will offer the same or lower return than less risky assets, then look to invest in high quality short term securities like Treasury Inflation Protected Securities (TIPS) . TIPS traditionally offer lower yield for less volatility, but they are becoming a preferred destination as the risk premium is absent in an inverted curve environment. Avoid long-term stocks and growth stocks that finance their expansion with high leverage, ie excessive borrowing.