Ian is a geopolitical forecaster and obtained his MBA from Villanova University.
The news this week has been filled with headlines warning about potential financial doom, and it’s all centered around three words: “Inverted Yield Curve.” What does that actually mean? We'll talk about bonds versus stocks, what an inverted yield curve actually means, and why it's so important.
High Risk And Low Risk
Before we dive into the subject, let’s talk about risk. Simply, the more risk you want to take on, the more money you can potentially make. That word “potentially” is the key: more risk means more of a chance you won’t make as much money as you expected, or even worse you’ll lose money.
If you want to invest more safely, the potential rewards are much lower. But that also means you reduce your chance of losing money.
Stocks: Risky Investment
When you think of investing, people often think about the stock market. A stock’s price isn’t fixed; it goes up or down depending on how well a company is performing.
Stock prices are risky; you buy them because you think the price will go up, but there’s no guarantee that'll happen. They could go up by one percent or 15%, or they could go down. You only make money if you can sell stocks for more than you paid.
If you’re looking for a safer investment, then you need to look outside the stock market.
Bonds: (Mostly) Safe Investment
Like companies, governments and municipalities often need to borrow money. They do this by selling bonds. A bond is like an IOU: you lend them money and they promise to pay it back with interest.
Bonds are much safer than stocks, and investors know they could probably get a higher return from stocks. But a lower rate of return is a good trade-off for the peace of mind.
You buy bonds for a set time period—say, ten years. You’ll get paid interest from that bond on a regular basis (usually every six months), and that interest rate is the yield. At the end of the set time period (when the bond matures), you get your original investment back.
Example: Bond Yield
Say you buy a $1,000 bond which promises 2% interest. That's an annual interest rate, so it’ll pay $20 in interest every year you have it. Most bonds split the interest into to two six-monthly payments, so you get $10 every six months. That’ll repeat every year until the end of the maturity period, when you get paid back your original $1,000 investment (just like an IOU).
Yields and Yield Curves
Generally, if you loan money to a government or company for a longer period of time, you'll get a higher interest rate, or yield.
Lending your money for several years means you can't use it for something else (what economists call opportunity cost). So the borrower has to make it more attractive to you.
That means if you buy a 10-year bond, you want to get a higher interest rate than if you buy a 2-year bond, to make up for the inconvenience of not having your money for so long. And, historically, that's how it's worked out.
Read More From Toughnickel
Yield Curves: 2-Year Versus 10-Year (2018-2019)
Yield Curves: 3-Month Versus 10-Year (2018-2019)
Inverted Yield Curve
These charts shows the 3-month, 2-year, and 10-year bond yields for Treasury bonds in 2018 and 2019. For most of that time, you've been able to get a better interest rate—a higher yield—by buying a longer-term bond. That's what you expect.
But the gap has been closing; the yield for 10-year bonds has been coming down to the point where it was not much higher than a 2-year bond rate. And then, on Wednesday August 14th, the 10-year bond yield fell lower than the 2-year bond yield. That's the notorious inverted yield curve.
Why Is the Yield Curve Important?
Although stocks are riskier than bonds, that risk comes with a reward; if you can tolerate the short term ups and downs, stocks generally give a higher return on your investment over the long term. So investors like to put money into the stock market because, even though it's very volatile from day to day, it tends to go up. Bonds are safer, but not as profitable.
But now the overall economy is looking shakier. Companies aren't performing so well, and there are many signs that there's worse to come. Investors are getting more pessimistic about how profitable companies will be over the next year or more. At some point investors lose confidence, sell their stocks to try and avoid losing money, and instead buy bonds because they're safer.
That, in turn, means the yields are going down. The old axiom about supply and demand holds true; if demand goes up for bonds, the government doesn't need to pay such a high interest rate to attract investors.
There are a lot of bond types, some as long as 30 years. But the 2 year and 10 year bond rates have traditionally been an extremely important comparison and is closely watched.
Will There Be a Recession?
The wording is important!
- Every recession in the last 60 years has occurred after yield curves have inverted.
- NOT every inverted yield curve occurrence has been followed by a recession!
In other words, it's important and is a warning sign to economists, but it doesn't mean a recession is inevitable. The economy is a complicated machine with many moving parts, and a single warning sign by itself is simply not enough to make a sure bet that there'll be a recession.
One other point to keep in mind is this doesn't happen immediately. When there has been a recession following a yield curve inversion, it took an average of 22 months from the warning signal of an inverted yield curve until the official start of a recession.
- A yield curve inversion means that short term Treasury bonds are giving a higher interest rate (yield) than longer term bonds.
- A short term investment usually pays less than a comparable long term investment, so this is concerning.
- It's widely regarded as an important sign that is often followed by a recession.
- But it's not infallible; an inverted yield curve sometimes isn't followed by a recession.
Now you know what an inverted yield curve is and why it's so important. Keep in mind that nobody can predict with certainty what will happen in the economy in the next 12 months or two years. But we can be sure there'll be plenty of speculation to come!
- Bonds | Investor.gov
What are bonds? A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time. When you buy a bond, you are lending to the issuer, which may be a government,
An inverted yield curve marks a point on a chart where short-term investments in U.S. Treasury bonds pay more than long-term ones.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
Ian Mundell (author) on August 21, 2019:
Thanks for the feedback! Let me know if there's any other topics you'd like me to write about.
Esteban Agosto Reid on August 20, 2019:
Interesting read...excellent piece...extremely informative and instructive...