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The U.S. Yield Curve Has Inverted

388 points by acdanger 8y ago

jstanley 8y ago
So I read the article but I don't quite get it. A 5-year bond now has a lower yield than a 3-year bond? How is that even possible? Wouldn't anyone who wants a 5-year bond just buy a 3-year bond and then put the cash under their mattress after 3 years? Is the idea that in 3 years' time, negative interest rates will be widespread, physical cash will be abolished, and figuratively keeping the cash under your mattress isn't even possible? EDIT: And why don't arbitrageurs buy up 3-year bonds and sell 5-year bonds?
- dickeytk 8y ago
  they buy the 5-year because they don't have trust in the US economy and want to lock into an interest rate before they decrease further
  - prostoalex 8y ago
    Yet they have enough trust in the US economy to assume that inflation won't ruin their earnings over the [longer] 5-year period.
- deleted 8y ago
  [deleted]
- sk5t 8y ago
  The 5-year yield is lower to mitigate the uncertain risk (to the issuer) of paying above-market during years 4 and 5.
- debt 8y ago
  "A 5-year bond now has a lower yield than a 3-year bond? How is that even possible? Wouldn't anyone who wants a 5-year bond just buy a 3-year bond and then put the cash under their mattress after 3 years?" Your confusion is precisely why it's a bad thing. Ideally, longer-term bonds have a higher yield, as that would mean we collectively are investing in high growth over a long period of time. That is, the economy grows. When the inversion happens, then the short-term bonds have a higher yield, which means something is wrong with the economy in the long term. We don't know what's wrong with it, it's just a signal.
- anilshanbhag 8y ago
  Thats not how it works. If 5-year bond has yield x, for principal P you receive Px for 5 years. With 3-year bond with yield y, you get Py for 3 years. If y > x => after 3 years rates will be lower than y. So you will get lower than P*y for the last 2 years (of 5 years).
  - jstanley 8y ago
    Ahh, got it. So the overall yield is not lower, just the annualised yield. That doesn't sound like nearly as much cause for alarm.
    - village-idiot 8y ago
      It's not a cause for alarm per se, but the inverted yield curve means that the bond market is feeling pessimistic. Rate inversions often happen before recessions, but they're not a fool-proof indicator.
    - adw 8y ago
      The alarm is that bond yields are more or less `yield = (k / economic confidence)` - if people are confident then they don't buy bonds, so the price of bonds falls, so the yield (which is annualized return) rises. (Thus recessions lead to falling interest rates as people seek safe harbors for money, making credit cheaper.) What this means is that the bond market thinks available bond yields for cash-on-hand will be lower in three years than five, so they're willing to take a hit now to lock in the longer-term payout. That reflects serious economic pessimism.
  - twic 8y ago
    Which is why i think that describing the yield curve in terms of rates of bonds running from now until some date in the future (which is what we do when we talk about raw treasury rates, or zero-coupon bond rates, another common form) is really unhelpful, because it disguises this structure. We should instead talk about it in terms of expected instantaneous, or at least short-term, forward rates. For example, what is the expected rate for a three-month T-bill starting 1, 2, 3, 4, or 5 years from now?
- dawhizkid 8y ago
  I see it as investors betting that before 5 years from now we'll see another recession and the Fed will be forced to lower interest rates, hence why 5 year yields are trading below 3 year yields.
- jsight 8y ago
  Right, but the 3 year bond would only pay 3 years of interest. If interest rates are significantly lower 3 years from now, then reinvesting in a new (lower interest) bond at that point would give you a lower return over 5 years than the marginally lower 5 year bond would give you now. So, why does this happen? Well, it happens when the markets expect interest rates to drop between now and five years from now. Why might that expectation exist? Well, it might if bond buyers were anticipating a recession. At least that is how I understand it. Feel free to correct me.
- JumpCrisscross 8y ago
  > A 5-year bond now has a lower yield than a 3-year bond? How is that even possible? Wouldn't anyone who wants a 5-year bond just buy a 3-year bond and then put the cash under their mattress after 3 years? Today's rates show the 3-year yielding 284bps and the 5-year yielding 283bps (the same as the 2-year) [1]. Let's consider three hypothetical buyers' outcomes. To keep things simple, we'll assume interest isn't re-invested. One buys the 5-year. $10,000 of their principal would turn out $1,415 in interest [2]. Another buys the 3-year, keeping the principal as cash on redemption. $10,000 of their principal turns into $852 in interest [3]. Immediately, you see why the 5-year is a better buy for a 5-year investment horizon than the 3-year. Consider a third buyer. They buy the 3-year with the aim of re-investing. To get the $563 difference between the 5-year and 3-year total interest pay-outs, they would need to buy a 2-year bond yielding 282bps when the 3-year matures [4]. If rates are lower 3 years' hence, the 5-year investor will have done better. If rates are higher, the 3-year buyer with intent on reinvesting will have done better. This reinvestment risk, which incorporates the market's views on future interest rates, is what the yield curve essentially reflects. [1] https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield https://www.treasury.gov/resource-center/data-chart-center/i... [2] 2.83% x $10,000 x 5 years [3] 2.84% x $10,000 x 3 years [4] [($1,415 - $852) / 2] / $10,000
- markvdb 8y ago
  An inverse yield curve predicts lower interest rates in the future as longer-term bonds are being demanded, sending the yields down.
- pjc50 8y ago
  At large enough scale there is no mattress. Keeping a billion in cash has storage and transport overhead, while keeping it in bonds is a simple matter of accounting.
  - dssu 8y ago
    Maybe you will have a billion in physical cash if you are running a narco empire
- AlexCoventry 8y ago
  Suppose for instance you believe that the Federal Reserve's fiscal policy calls for it to raise short-term interest rates, and you expect that to cause a rise in long-term rates shortly as well. That belief would reduce your appetite for longer-term bonds, for the time being.
madamelic 8y ago
Can someone explain this in dumb person language? All I get is that the yield that bonds give is below zero, meaning you lose money holding them? And bonds are buying debt on faith the issuer will pay, and as the issuer pays, you get dividends. And I think the interest rate is inversely proportional to the amount the bonds pay or something like that? Just explain in simple language. :)
- ceejayoz 8y ago
  It's a potential warning sign of a coming recession: https://en.wikipedia.org/wiki/Yield_curve#Relationship_to_the_business_cycle https://en.wikipedia.org/wiki/Yield_curve#Relationship_to_th...
- dawhizkid 8y ago
  No - what happened is the yield on the 5 year treasury dropped below the 3 year one.
- Bajeezus 8y ago
  It's significant because an inverted yield curve is a historical indicator of an impending recession. https://www.nytimes.com/2018/06/25/business/what-is-yield-curve-recession-prediction.html https://www.nytimes.com/2018/06/25/business/what-is-yield-cu...
- bunderbunder 8y ago
  Not quite that. The yield for a 5-year note is less than the yield for a 3-year note. More generally, a yield curve inversion is when the interest rate you earn on short-term debt ends up higher than that of long-term debt of the same quality. I don't think the issue is that the inversion causes the recession. It's more an indicator of pessimism in the market. It implies that investors think that interest rates are going to get worse, so they look to buy more longer-term bonds in order to try and lock in current yields for a longer period of time. That increases demand for those assets, which drives down their price^H^H^H^H^H yields.
  - deleted 8y ago
    [deleted]
nu2ycombinator 8y ago
Is it Good or Bad? And in what way?
- quotemstr 8y ago
  It's very bad, in the short term. It means that investors expect an economic recession soon. We're about due for one. It's going to be especially fun this time, since a lot of people have investments running on autopilot. In the long term, regular recessions are healthy, since they clear out accumulated fraud and deadweight, forcing people to make necessary but unpleasant hard decisions.
  - Diederich 8y ago
    The article said the last such inversion preceded the recession by 28 months.
- throwawaymath 8y ago
  "Good" and "bad" aren't nuanced enough terms for the discussion. What has happened is a classical indicator of a recession has emerged, because investors are demonstrating pessimism about long term bond yields compared to near term bond yields. This does not mean we are presently in a recession, nor does it mean we are necessarily entering one soon. But the indicator has historically correlated with recessions (consistently since 1970 if I recall correctly). A better question for you to ask is this: what does my investment portfolio look like and when do I expect to withdraw from it? It's healthy for economies to go through credit/debt prosperity cycles, but this will be concerning for you if you (among other things) plan to withdraw a nontrivial amount of your investment fund(s) in the near future. If your employment situation is stable and you're not planning any large withdrawals, this is probably not something to immediately worry about. If you work in an industry which benefits from greater volatility, this might actually be beneficial for you.
  - shostack 8y ago
    >"If your employment situation is stable and you're not planning any large withdrawals, this is probably not something to immediately worry about." This is an important note. If we do face another Black Swan event like the housing crisis, it may not be directly related to housing in the same way. As such, it signals a general "be on alert" from a risk standpoint. If you would be in serious trouble financially if you lost your job tomorrow, you may want to shore up your cash position to ensure you have a way to ride things out. If you feel relatively secure, you may want to free up some liquidity for opportunities that might present themselves. If you're about to buy a house, now might be a good time to move those funds out of the market, or consider the timing of your purchase altogether. These are just a few considerations.
gibybo 8y ago
There is a 1 bps spread between the 3-year and 5-year US Treasury (2.84 vs 2.83) as of close of market today. While somewhat noteworthy, it's not huge (yet). When people talk about yield curve inversion and it being an indicator of recessions, it's much more common to compare the 2-year with the 10-year. Currently that sits at 2.83 (2yr) vs 2.98 (10yr). While the shorter spreads do often invert first, there is no requirement for the longer spreads to follow.
- acdanger 8y ago
  Here's a graph plotting the 10 vs 2 year spread: https://fred.stlouisfed.org/series/T10Y2Y https://fred.stlouisfed.org/series/T10Y2Y
  - Obi_Juan_Kenobi 8y ago
    Going off of that graph, we could 'bounce' and remain at non-inverted levels for a few more years as in 1995. But once the rates truly are inverted to a substantial degree, a recession generally follows within a couple years.
    - freehunter 8y ago
      1995 was special, though, since that was the start of the Dotcom boom. Every year after 1995 and before 2000, the Dotcom bubble got bigger and bigger. To bounce like 1995, we'd need an economy like 1995.
- sdinsn 8y ago
  > While the shorter spreads do often invert first, there is no requirement for the longer spreads to follow. I mean, there's no "requirement", but historically their movements correlate with each other closely with a small amount of offset.
  - gibybo 8y ago
    Sure, but I guess what I'm trying to say is that the probability of the longer spreads inverting based on this is nowhere near 100%. A tiny amount of good news in the market tomorrow will probably reverse this short term spread inversion. Bad news will likely make it worse, but it's not really at a level yet where it's indicating much yet imo.
NTDF9 8y ago
Can someone concisely explain what yield curve inversion could indicate? I can think of a few explanations for why long term yields are going lower: 1. Long term yields going lower because there are far fewer places for capital to go to besides US treasuries, indicating slower business activity 2. Short term yields going higher because no one wants to buy short-term treasuries because there's something else to invest in or expect higher return for short term investment? Are these the only two reasons? Why are people so fearful of inverted yield curves?
- seveneightn9ne 8y ago
  Investors want to buy long term bonds because they suspect the interest rates will get worse, so they want to lock in the current rate for a longer time. It signals that investors are expecting a recession.
- tedsanders 8y ago
  Inverted yield curves mean that interest rates are expected to fall. Interest rates falling mean that (a) demand for money is falling and/or (b) supply of money is rising. In economic recessions, the demand for money often falls and the supply of money often grows. Therefore, an inverted yield curve indicates an increased forecast of recession chances over the next few years. (I am not an expert and could be wrong.)
  - NTDF9 8y ago
    Good explanation. Thank you. But isn't the demand for money going to go up because the US is running ginormous deficits? I would expect the demand for money to be through the roof.
    - tedsanders 8y ago
      [Edited] As described by the IS-LM model, government deficits tend to do three things: -Increase output (more people working/getting paid) -Decrease economic investment (investors put dollars in treasuries instead of private sector projects) -Increase interest rates (fewer investor dollars to go toward private sector projects, since some have been diverted to government debt/production) However, the Fed usually tries to account for this force in their monetary policy (see monetary offset):https://www.bloomberg.com/opinion/articles/2018-07-20/fed-impact-on-deficit-has-nothing-to-do-with-trump https://www.bloomberg.com/opinion/articles/2018-07-20/fed-im...
aportnoy 8y ago
> All it means is that the central bank will probably leave interest rates steady, or even cut a bit, in 2022 or 2023. This event reflects the relative preference of the markets for the 5 yrs compared to 3 yrs, producing lower effective yields. This is probably done to secure a certain rate for a longer period of time.
deleted 8y ago
[deleted]
jameslk 8y ago
If anyone is curious how this has compared over time for more context, this is a great visual tool to graph/animate the yield curve: https://stockcharts.com/freecharts/yieldcurve.php https://stockcharts.com/freecharts/yieldcurve.php
jakelarkin 8y ago
a better way to understand the causality between yield curves and recessions is to look at it from the perspective of the banking sector ... banks/lenders primarily borrow short-term and lend long-term. They pay depositors short-term rates and earn the long term rates on loans. If this carry trade turns negative, it makes it difficult to make money lending, they get more conservative and collectively they tighten credit conditions on the economy as whole.
jf- 8y ago
Question: Are there any other recession signals which have also recently presented themselves? I know very low unemployment, which we have, is one. Are there others?
- ep103 8y ago
  I've heard that container shipping, and container shipping fleet expansion are important indicators, but I've also read that it went haywire in 2008, and the tradewar isn't helping.
- therealdrag0 8y ago
  NPR's "Planet Money: The Indicator" Just did two episodes on this: https://www.npr.org/sections/money/2018/11/16/668745229/recession-indicators-pt-1 https://www.npr.org/sections/money/2018/11/16/668745229/rece... https://www.npr.org/sections/money/2018/11/19/669368782/recession-indicators-pt-2 https://www.npr.org/sections/money/2018/11/19/669368782/rece...
howard941 8y ago
Is this a result (in part or more) of setting a schedule for fed funds rate increases and sticking to it?
chadash 8y ago
A quick explanation in layman's terms: I have money on hand and I want to put it into something safe. The US government is constitutionally bound to pay its debts, and is generally considered to be very safe (if not the safest investment around). The US government sells bonds with different terms. I can buy 1 year bonds, 3 year bonds, 5 year bonds, 10 year bonds, etc. The treasury sets a fixed interest rate and face value on treasury notes and then whoever pays the most gets the note. Right now, (annualized) rates [1] are approximately as follows: 1 month - 2.30% 6 month - 2.56% 1 year - 2.72% 3 year - 2.84% 5 year - 2.83% 7 year - 2.90% 10 year - 2.98% Notice that the 3 year rates are higher than the 5 year rates. Generally speaking, if I'm going to lock up my money for more time, I expect a higher return. However, today, the 3 year notes are getting a higher rate of return than the 5 year notes. Why? Interest rates generally tend to follow the economy at large. When the economy is doing well, people will invest in stocks and other investments and are less willing to pay for the safety of treasuries, so effective rates go up when people bid less at treasury auctions (additionally, the government will take steps via the Federal Reserve to make rates higher). By the same token, when the economy isn't doing well, people want the safety of treasuries, even if they pay less, so effective rates on treasuries tend to go down. In rare cases, the yield curve will invert. What this means is that investors think that rates of return on government bonds are going to go down in the future. In order to lock in a better rate now, they're willing to pay more for longer term bonds (in this case, 5 year bonds vs. 3 year bonds) in order to "lock-in" the good rates. The assumption is that they won't be able to get the same good rates if they don't act now. Note that only the 3 and 5 years have inverted. If people were really panicked, you would probably see a more significant inversion, where for example, the 1 year was higher than the 2 year and the 2 higher than the 3, etc. [1] these rates are actual rates of return calculated based on the auction price paid
- Waterluvian 8y ago
  Thanks for this. It really helped. So if we look at the very long term rates, do those signal that we are broadly confident that the US economy will be healthy long term? Or is there no signal there?
  - 8y ago
mikhailfranco 8y ago
Banks borrow short and lend long. Meaning they take short-term deposits (e.g. current account balances) and make long-term loans (e.g. mortgages). They normally make a profit, because they borrow short paying low rates, and lend long receiving high rates. Easy. Head to the golf course. If the yield curve inverts, banks lose money ... their capital ratios and share prices fall ... they become more risky and less creditworthy ... people withdraw their money ... bank runs, ATMs stop working, bail-ins ... your current account is permanently unavailable (see Cyprus, Greece). Note that many banks, especially European banks, are starting from an existing almost-bankrupt state, with plummeting share prices (DB, UniCredit, BBVA, BNP). If the EUR yield curve inverts, they all crash faster than an anvil without a parachute (DB is already giving the anvil a good race).
elvirs 8y ago
so there is starting to begin some panic but its not in full swing yet.
tabtab 8y ago
Based on past patterns, we now have about 15 months before a formal recession is declared. This is rough and imperfect, but many other metrics are pointing to both the end of the bull market and a coming recession. I've been monitoring the econ because I plan to invest in real-estate and stocks during the next slump. [Corrected "bear" typo.]
- cm2187 8y ago
  * the end of the bull market
- shostack 8y ago
  >"I've been monitoring the econ because I plan to invest in real-estate and stocks during the next slump." Which raises the question of "isn't every other investor?" And if that's the case, how much of that has the market already factored into pricing? For example, I hear a lot of people in the Bay Area talking about saving up for when the next crash occurs so they can buy real estate cheap. But if there's sufficient pent up demand and capital, that can dampen the impact like what appears to have happened with the 2008 recession[1], only perhaps magnified after this bull run. [1] https://www.bayareamarketreports.com/trend/3-recessions-2-bubbles-and-a-baby https://www.bayareamarketreports.com/trend/3-recessions-2-bu...
  - tabtab 8y ago
    Going back roughly 4 decades, the best time to buy real-estate for investment has been during or just after recessions. Have investors changed after those four decades? If by chance real-estate doesn't go down during the next slump, then perhaps stocks will; I got choice. It's unlikely that neither will shift downward, and I might skip investing if both stay high. Interest rates on constructed real-estate is also lower during slumps. Of course investors could be wrong, it happens. But buy-low-sell-high has on average worked best. It's one of Warren Buffett's key strategies (although arguable he is buy-low-and-keep).
- airstrike 8y ago
  Keep in mind the next recession may very well not have anything to do with real estate. We also just went through a prolonged period of record low interest rates during which you could finance real estate really cheaply (though prices could have been inflated from excess demand, but [a] I'm no real estate expert and [b] this could vary significantly from location to location).
cinquemb 8y ago
One thing I'm interested to see if anyone can discuss what's different this time (i.e, Fed has ~4x more assets on it's balance sheet [and the roll-offs], corporate have ~2x more debt, labor force participation rate is at levels not seen since the 60's, 4 eurodollar "events" since, US gov debt levels since) and how it could theoretically affect the yield gymnastics? Some banks keep saying 2020 is the big one since that's when most of the corporate debt will be need to rolled over onto higher rates, but I'm of the mind we don't even make it that far because of even shorter term liabilities (think corporate buybacks with debt at higher rates that will increasingly put pressure on balance sheets m/m, liquidity pressure risk assets, devaluation on collateral) in this environment.
- schlumpf 8y ago
  Good questions. Two differences to consider vis a vis past late cycle moments: US corporate profits haven't peaked, and the politicians could have a better claim on being part of the problem than on being part of the solution. I was tempted to add "leverage" but that's too slippery for a concise discussion. Profits: it took about two years peak-to-trough for profits/GDP to correct during the past two recessions. Unless you see sudden stop risk, this suggests the US corprorate sector isn't staring down the barrel of a massive deleveraging...yet. Politics: public support for legislative non-compromise does not speak to the kinds of policy fixes applied in 2008-9. Executive belligerence toward the Fed doesn't seem helpful either. As much as markets may have appeared to ignore US political risks while momentum was positive, it seems credulous to think this more of a divorce than a separation. There are other quantitative arguments that the turn in the cycle is not here yet (e.g. employment, notwithstanding participation rate). But the prospect of a return to political gridlock is, to me, the most important risk contrast with recent past cycles.
RayVR 8y ago
This is not the typical yield spread a practitioner or the fed would look at.
- umeshunni 8y ago
  Would they look at 7 and 10 year yield spreads?
  - airstrike 8y ago
    I believe the 10- and 2-year yields are most often compared. https://fred.stlouisfed.org/series/T10Y2Y https://fred.stlouisfed.org/series/T10Y2Y
neurobashing 8y ago
Fans of Planet Money’s “The Indicator” are no doubt imagining Cardiff prepping new yield curve material.
- vyrotek 8y ago
  I immediately thought of this too. Can't wait for the episode.
- ric2b 8y ago
  Yup, I love that he's so enthusiastic about the yield curve that I was immediately reminded of him when I read the title.
jgalt212 8y ago
It doesn't have to be this way. The curve was unnaturally flat to start with due to Operation Twist. As the Fed unwinds its balance sheet, it seems only naturally to also unwind the effects of Operation Twist at the same time.
apo 8y ago
Worth noting that unlike previous business cycles the Fed is manipulating both the long and short end of the curve. Quantitative Tightening (QT) is the Fed's program to sell and/or let expire the long-term Treasuries it bought during QE 1/2/3. As the same time, the Fed is raising short term interest rates using its tried-and true headline short-term interest rate target. This is not just unusual - it's unprecedented. QT has the effect of suppressing the yield curve inversion signal (by artificially increasing long-term rates). As a result, the gap between the next yield curve inversion (the one mentioned in the article hardly qualifies) and the next recession could be surprisingly short. Backing off now on QT and short term raising, with unemployment at a very low point and inflation ramping up, would be lethal to the Fed's credibility. Whatever Powell says to try to talk the stock market up, he's locked and loaded and can't do much beyond stick with the program: triggering the next recession.
- ep103 8y ago
  Why can't he slow QT?
  - cinquemb 8y ago
    > QT has the effect of suppressing the yield curve inversion signal (by artificially increasing long-term rates) i.e they could, but the long end yields will drop below where they are now, on top of signaling to the market that things are worse than what is admitted if they have to stop.
- Jonanin 8y ago
  This is a bit alarmist. Please see [1] or [2] for Jerome Powell's thoughts on recent yield curve trends and what it means for the economy. [1] https://www.bondbuyer.com/articles/powell-doesnt-see-high-recession-risk-though-eyeing-yield-curve https://www.bondbuyer.com/articles/powell-doesnt-see-high-re... [2] https://www.youtube.com/watch?v=p7Z46p06WS4 https://www.youtube.com/watch?v=p7Z46p06WS4
- Havoc 8y ago
  Meanwhile I'm sitting in all cash thinking "Hurry the f up". (Yes yes I know don't time the market)
Tsubasachan 8y ago
All those Princeton and Harvard economists travelling the world telling foreign governments how to run their economy lol. Does any politician in the US even read the emails the Fed sends them? Must be the most thankless job ever.
philjohn 8y ago
Interesting use of the Smiler RollerCoaster in the lead photo. It was involved in a serious crash a few years ago.
ChrisPodlaski 8y ago
Inverted yield curve has predicted 10 of the last 3 recessions
- jakelarkin 8y ago
  on a 2 year window its pretty accurate. https://fred.stlouisfed.org/series/T10Y2Y https://fred.stlouisfed.org/series/T10Y2Y Max view also true that 2 years a very long time for an economic/investment hypothesis to play out

388 points by acdanger 8y ago

So I read the article but I don't quite get it. A 5-year bond now has a lower yield than a 3-year bond? How is that even possible? Wouldn't anyone who wants a 5-year bond just buy a 3-year bond and then put the cash under their mattress after 3 years? Is the idea that in 3 years' time, negative interest rates will be widespread, physical cash will be abolished, and figuratively keeping the cash under your mattress isn't even possible? EDIT: And why don't arbitrageurs buy up 3-year bonds and sell 5-year bonds?

dickeytk 8y ago
they buy the 5-year because they don't have trust in the US economy and want to lock into an interest rate before they decrease further
- prostoalex 8y ago
  Yet they have enough trust in the US economy to assume that inflation won't ruin their earnings over the [longer] 5-year period.
deleted 8y ago
[deleted]
sk5t 8y ago
The 5-year yield is lower to mitigate the uncertain risk (to the issuer) of paying above-market during years 4 and 5.
debt 8y ago
"A 5-year bond now has a lower yield than a 3-year bond? How is that even possible? Wouldn't anyone who wants a 5-year bond just buy a 3-year bond and then put the cash under their mattress after 3 years?" Your confusion is precisely why it's a bad thing. Ideally, longer-term bonds have a higher yield, as that would mean we collectively are investing in high growth over a long period of time. That is, the economy grows. When the inversion happens, then the short-term bonds have a higher yield, which means something is wrong with the economy in the long term. We don't know what's wrong with it, it's just a signal.
anilshanbhag 8y ago
Thats not how it works. If 5-year bond has yield x, for principal P you receive Px for 5 years. With 3-year bond with yield y, you get Py for 3 years. If y > x => after 3 years rates will be lower than y. So you will get lower than P*y for the last 2 years (of 5 years).
- jstanley 8y ago
  Ahh, got it. So the overall yield is not lower, just the annualised yield. That doesn't sound like nearly as much cause for alarm.
  - village-idiot 8y ago
    It's not a cause for alarm per se, but the inverted yield curve means that the bond market is feeling pessimistic. Rate inversions often happen before recessions, but they're not a fool-proof indicator.
  - adw 8y ago
    The alarm is that bond yields are more or less `yield = (k / economic confidence)` - if people are confident then they don't buy bonds, so the price of bonds falls, so the yield (which is annualized return) rises. (Thus recessions lead to falling interest rates as people seek safe harbors for money, making credit cheaper.) What this means is that the bond market thinks available bond yields for cash-on-hand will be lower in three years than five, so they're willing to take a hit now to lock in the longer-term payout. That reflects serious economic pessimism.
- twic 8y ago
  Which is why i think that describing the yield curve in terms of rates of bonds running from now until some date in the future (which is what we do when we talk about raw treasury rates, or zero-coupon bond rates, another common form) is really unhelpful, because it disguises this structure. We should instead talk about it in terms of expected instantaneous, or at least short-term, forward rates. For example, what is the expected rate for a three-month T-bill starting 1, 2, 3, 4, or 5 years from now?
dawhizkid 8y ago
I see it as investors betting that before 5 years from now we'll see another recession and the Fed will be forced to lower interest rates, hence why 5 year yields are trading below 3 year yields.
jsight 8y ago
Right, but the 3 year bond would only pay 3 years of interest. If interest rates are significantly lower 3 years from now, then reinvesting in a new (lower interest) bond at that point would give you a lower return over 5 years than the marginally lower 5 year bond would give you now. So, why does this happen? Well, it happens when the markets expect interest rates to drop between now and five years from now. Why might that expectation exist? Well, it might if bond buyers were anticipating a recession. At least that is how I understand it. Feel free to correct me.
JumpCrisscross 8y ago
> A 5-year bond now has a lower yield than a 3-year bond? How is that even possible? Wouldn't anyone who wants a 5-year bond just buy a 3-year bond and then put the cash under their mattress after 3 years? Today's rates show the 3-year yielding 284bps and the 5-year yielding 283bps (the same as the 2-year) [1]. Let's consider three hypothetical buyers' outcomes. To keep things simple, we'll assume interest isn't re-invested. One buys the 5-year. $10,000 of their principal would turn out $1,415 in interest [2]. Another buys the 3-year, keeping the principal as cash on redemption. $10,000 of their principal turns into $852 in interest [3]. Immediately, you see why the 5-year is a better buy for a 5-year investment horizon than the 3-year. Consider a third buyer. They buy the 3-year with the aim of re-investing. To get the $563 difference between the 5-year and 3-year total interest pay-outs, they would need to buy a 2-year bond yielding 282bps when the 3-year matures [4]. If rates are lower 3 years' hence, the 5-year investor will have done better. If rates are higher, the 3-year buyer with intent on reinvesting will have done better. This reinvestment risk, which incorporates the market's views on future interest rates, is what the yield curve essentially reflects. [1] https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield https://www.treasury.gov/resource-center/data-chart-center/i... [2] 2.83% x $10,000 x 5 years [3] 2.84% x $10,000 x 3 years [4] [($1,415 - $852) / 2] / $10,000
markvdb 8y ago
An inverse yield curve predicts lower interest rates in the future as longer-term bonds are being demanded, sending the yields down.
pjc50 8y ago
At large enough scale there is no mattress. Keeping a billion in cash has storage and transport overhead, while keeping it in bonds is a simple matter of accounting.
- dssu 8y ago
  Maybe you will have a billion in physical cash if you are running a narco empire
AlexCoventry 8y ago
Suppose for instance you believe that the Federal Reserve's fiscal policy calls for it to raise short-term interest rates, and you expect that to cause a rise in long-term rates shortly as well. That belief would reduce your appetite for longer-term bonds, for the time being.

madamelic 8y ago

Can someone explain this in dumb person language? All I get is that the yield that bonds give is below zero, meaning you lose money holding them? And bonds are buying debt on faith the issuer will pay, and as the issuer pays, you get dividends. And I think the interest rate is inversely proportional to the amount the bonds pay or something like that? Just explain in simple language. :)

ceejayoz 8y ago
It's a potential warning sign of a coming recession: https://en.wikipedia.org/wiki/Yield_curve#Relationship_to_the_business_cycle https://en.wikipedia.org/wiki/Yield_curve#Relationship_to_th...
dawhizkid 8y ago
No - what happened is the yield on the 5 year treasury dropped below the 3 year one.
Bajeezus 8y ago
It's significant because an inverted yield curve is a historical indicator of an impending recession. https://www.nytimes.com/2018/06/25/business/what-is-yield-curve-recession-prediction.html https://www.nytimes.com/2018/06/25/business/what-is-yield-cu...
bunderbunder 8y ago
Not quite that. The yield for a 5-year note is less than the yield for a 3-year note. More generally, a yield curve inversion is when the interest rate you earn on short-term debt ends up higher than that of long-term debt of the same quality. I don't think the issue is that the inversion causes the recession. It's more an indicator of pessimism in the market. It implies that investors think that interest rates are going to get worse, so they look to buy more longer-term bonds in order to try and lock in current yields for a longer period of time. That increases demand for those assets, which drives down their price^H^H^H^H^H yields.
- deleted 8y ago
  [deleted]

nu2ycombinator 8y ago

Is it Good or Bad? And in what way?

quotemstr 8y ago
It's very bad, in the short term. It means that investors expect an economic recession soon. We're about due for one. It's going to be especially fun this time, since a lot of people have investments running on autopilot. In the long term, regular recessions are healthy, since they clear out accumulated fraud and deadweight, forcing people to make necessary but unpleasant hard decisions.
- Diederich 8y ago
  The article said the last such inversion preceded the recession by 28 months.
throwawaymath 8y ago
"Good" and "bad" aren't nuanced enough terms for the discussion. What has happened is a classical indicator of a recession has emerged, because investors are demonstrating pessimism about long term bond yields compared to near term bond yields. This does not mean we are presently in a recession, nor does it mean we are necessarily entering one soon. But the indicator has historically correlated with recessions (consistently since 1970 if I recall correctly). A better question for you to ask is this: what does my investment portfolio look like and when do I expect to withdraw from it? It's healthy for economies to go through credit/debt prosperity cycles, but this will be concerning for you if you (among other things) plan to withdraw a nontrivial amount of your investment fund(s) in the near future. If your employment situation is stable and you're not planning any large withdrawals, this is probably not something to immediately worry about. If you work in an industry which benefits from greater volatility, this might actually be beneficial for you.
- shostack 8y ago
  >"If your employment situation is stable and you're not planning any large withdrawals, this is probably not something to immediately worry about." This is an important note. If we do face another Black Swan event like the housing crisis, it may not be directly related to housing in the same way. As such, it signals a general "be on alert" from a risk standpoint. If you would be in serious trouble financially if you lost your job tomorrow, you may want to shore up your cash position to ensure you have a way to ride things out. If you feel relatively secure, you may want to free up some liquidity for opportunities that might present themselves. If you're about to buy a house, now might be a good time to move those funds out of the market, or consider the timing of your purchase altogether. These are just a few considerations.

gibybo 8y ago

There is a 1 bps spread between the 3-year and 5-year US Treasury (2.84 vs 2.83) as of close of market today. While somewhat noteworthy, it's not huge (yet). When people talk about yield curve inversion and it being an indicator of recessions, it's much more common to compare the 2-year with the 10-year. Currently that sits at 2.83 (2yr) vs 2.98 (10yr). While the shorter spreads do often invert first, there is no requirement for the longer spreads to follow.

acdanger 8y ago
Here's a graph plotting the 10 vs 2 year spread: https://fred.stlouisfed.org/series/T10Y2Y https://fred.stlouisfed.org/series/T10Y2Y
- Obi_Juan_Kenobi 8y ago
  Going off of that graph, we could 'bounce' and remain at non-inverted levels for a few more years as in 1995. But once the rates truly are inverted to a substantial degree, a recession generally follows within a couple years.
  - freehunter 8y ago
    1995 was special, though, since that was the start of the Dotcom boom. Every year after 1995 and before 2000, the Dotcom bubble got bigger and bigger. To bounce like 1995, we'd need an economy like 1995.
sdinsn 8y ago
> While the shorter spreads do often invert first, there is no requirement for the longer spreads to follow. I mean, there's no "requirement", but historically their movements correlate with each other closely with a small amount of offset.
- gibybo 8y ago
  Sure, but I guess what I'm trying to say is that the probability of the longer spreads inverting based on this is nowhere near 100%. A tiny amount of good news in the market tomorrow will probably reverse this short term spread inversion. Bad news will likely make it worse, but it's not really at a level yet where it's indicating much yet imo.

NTDF9 8y ago

Can someone concisely explain what yield curve inversion could indicate? I can think of a few explanations for why long term yields are going lower: 1. Long term yields going lower because there are far fewer places for capital to go to besides US treasuries, indicating slower business activity 2. Short term yields going higher because no one wants to buy short-term treasuries because there's something else to invest in or expect higher return for short term investment? Are these the only two reasons? Why are people so fearful of inverted yield curves?

seveneightn9ne 8y ago
Investors want to buy long term bonds because they suspect the interest rates will get worse, so they want to lock in the current rate for a longer time. It signals that investors are expecting a recession.
tedsanders 8y ago
Inverted yield curves mean that interest rates are expected to fall. Interest rates falling mean that (a) demand for money is falling and/or (b) supply of money is rising. In economic recessions, the demand for money often falls and the supply of money often grows. Therefore, an inverted yield curve indicates an increased forecast of recession chances over the next few years. (I am not an expert and could be wrong.)
- NTDF9 8y ago
  Good explanation. Thank you. But isn't the demand for money going to go up because the US is running ginormous deficits? I would expect the demand for money to be through the roof.
  - tedsanders 8y ago
    [Edited] As described by the IS-LM model, government deficits tend to do three things: -Increase output (more people working/getting paid) -Decrease economic investment (investors put dollars in treasuries instead of private sector projects) -Increase interest rates (fewer investor dollars to go toward private sector projects, since some have been diverted to government debt/production) However, the Fed usually tries to account for this force in their monetary policy (see monetary offset):https://www.bloomberg.com/opinion/articles/2018-07-20/fed-impact-on-deficit-has-nothing-to-do-with-trump https://www.bloomberg.com/opinion/articles/2018-07-20/fed-im...

aportnoy 8y ago

> All it means is that the central bank will probably leave interest rates steady, or even cut a bit, in 2022 or 2023. This event reflects the relative preference of the markets for the 5 yrs compared to 3 yrs, producing lower effective yields. This is probably done to secure a certain rate for a longer period of time.

deleted 8y ago

[deleted]

jameslk 8y ago

If anyone is curious how this has compared over time for more context, this is a great visual tool to graph/animate the yield curve: https://stockcharts.com/freecharts/yieldcurve.php https://stockcharts.com/freecharts/yieldcurve.php

jakelarkin 8y ago

a better way to understand the causality between yield curves and recessions is to look at it from the perspective of the banking sector ... banks/lenders primarily borrow short-term and lend long-term. They pay depositors short-term rates and earn the long term rates on loans. If this carry trade turns negative, it makes it difficult to make money lending, they get more conservative and collectively they tighten credit conditions on the economy as whole.

jf- 8y ago

Question: Are there any other recession signals which have also recently presented themselves? I know very low unemployment, which we have, is one. Are there others?

ep103 8y ago
I've heard that container shipping, and container shipping fleet expansion are important indicators, but I've also read that it went haywire in 2008, and the tradewar isn't helping.
therealdrag0 8y ago
NPR's "Planet Money: The Indicator" Just did two episodes on this: https://www.npr.org/sections/money/2018/11/16/668745229/recession-indicators-pt-1 https://www.npr.org/sections/money/2018/11/16/668745229/rece... https://www.npr.org/sections/money/2018/11/19/669368782/recession-indicators-pt-2 https://www.npr.org/sections/money/2018/11/19/669368782/rece...

howard941 8y ago

Is this a result (in part or more) of setting a schedule for fed funds rate increases and sticking to it?

chadash 8y ago

A quick explanation in layman's terms: I have money on hand and I want to put it into something safe. The US government is constitutionally bound to pay its debts, and is generally considered to be very safe (if not the safest investment around). The US government sells bonds with different terms. I can buy 1 year bonds, 3 year bonds, 5 year bonds, 10 year bonds, etc. The treasury sets a fixed interest rate and face value on treasury notes and then whoever pays the most gets the note. Right now, (annualized) rates [1] are approximately as follows: 1 month - 2.30% 6 month - 2.56% 1 year - 2.72% 3 year - 2.84% 5 year - 2.83% 7 year - 2.90% 10 year - 2.98% Notice that the 3 year rates are higher than the 5 year rates. Generally speaking, if I'm going to lock up my money for more time, I expect a higher return. However, today, the 3 year notes are getting a higher rate of return than the 5 year notes. Why? Interest rates generally tend to follow the economy at large. When the economy is doing well, people will invest in stocks and other investments and are less willing to pay for the safety of treasuries, so effective rates go up when people bid less at treasury auctions (additionally, the government will take steps via the Federal Reserve to make rates higher). By the same token, when the economy isn't doing well, people want the safety of treasuries, even if they pay less, so effective rates on treasuries tend to go down. In rare cases, the yield curve will invert. What this means is that investors think that rates of return on government bonds are going to go down in the future. In order to lock in a better rate now, they're willing to pay more for longer term bonds (in this case, 5 year bonds vs. 3 year bonds) in order to "lock-in" the good rates. The assumption is that they won't be able to get the same good rates if they don't act now. Note that only the 3 and 5 years have inverted. If people were really panicked, you would probably see a more significant inversion, where for example, the 1 year was higher than the 2 year and the 2 higher than the 3, etc. [1] these rates are actual rates of return calculated based on the auction price paid

Waterluvian 8y ago
Thanks for this. It really helped. So if we look at the very long term rates, do those signal that we are broadly confident that the US economy will be healthy long term? Or is there no signal there?
- 8y ago

mikhailfranco 8y ago

Banks borrow short and lend long. Meaning they take short-term deposits (e.g. current account balances) and make long-term loans (e.g. mortgages). They normally make a profit, because they borrow short paying low rates, and lend long receiving high rates. Easy. Head to the golf course. If the yield curve inverts, banks lose money ... their capital ratios and share prices fall ... they become more risky and less creditworthy ... people withdraw their money ... bank runs, ATMs stop working, bail-ins ... your current account is permanently unavailable (see Cyprus, Greece). Note that many banks, especially European banks, are starting from an existing almost-bankrupt state, with plummeting share prices (DB, UniCredit, BBVA, BNP). If the EUR yield curve inverts, they all crash faster than an anvil without a parachute (DB is already giving the anvil a good race).

elvirs 8y ago

so there is starting to begin some panic but its not in full swing yet.

tabtab 8y ago

Based on past patterns, we now have about 15 months before a formal recession is declared. This is rough and imperfect, but many other metrics are pointing to both the end of the bull market and a coming recession. I've been monitoring the econ because I plan to invest in real-estate and stocks during the next slump. [Corrected "bear" typo.]

cm2187 8y ago
* the end of the bull market
shostack 8y ago
>"I've been monitoring the econ because I plan to invest in real-estate and stocks during the next slump." Which raises the question of "isn't every other investor?" And if that's the case, how much of that has the market already factored into pricing? For example, I hear a lot of people in the Bay Area talking about saving up for when the next crash occurs so they can buy real estate cheap. But if there's sufficient pent up demand and capital, that can dampen the impact like what appears to have happened with the 2008 recession[1], only perhaps magnified after this bull run. [1] https://www.bayareamarketreports.com/trend/3-recessions-2-bubbles-and-a-baby https://www.bayareamarketreports.com/trend/3-recessions-2-bu...
- tabtab 8y ago
  Going back roughly 4 decades, the best time to buy real-estate for investment has been during or just after recessions. Have investors changed after those four decades? If by chance real-estate doesn't go down during the next slump, then perhaps stocks will; I got choice. It's unlikely that neither will shift downward, and I might skip investing if both stay high. Interest rates on constructed real-estate is also lower during slumps. Of course investors could be wrong, it happens. But buy-low-sell-high has on average worked best. It's one of Warren Buffett's key strategies (although arguable he is buy-low-and-keep).
airstrike 8y ago
Keep in mind the next recession may very well not have anything to do with real estate. We also just went through a prolonged period of record low interest rates during which you could finance real estate really cheaply (though prices could have been inflated from excess demand, but [a] I'm no real estate expert and [b] this could vary significantly from location to location).

cinquemb 8y ago

One thing I'm interested to see if anyone can discuss what's different this time (i.e, Fed has ~4x more assets on it's balance sheet [and the roll-offs], corporate have ~2x more debt, labor force participation rate is at levels not seen since the 60's, 4 eurodollar "events" since, US gov debt levels since) and how it could theoretically affect the yield gymnastics? Some banks keep saying 2020 is the big one since that's when most of the corporate debt will be need to rolled over onto higher rates, but I'm of the mind we don't even make it that far because of even shorter term liabilities (think corporate buybacks with debt at higher rates that will increasingly put pressure on balance sheets m/m, liquidity pressure risk assets, devaluation on collateral) in this environment.

schlumpf 8y ago
Good questions. Two differences to consider vis a vis past late cycle moments: US corporate profits haven't peaked, and the politicians could have a better claim on being part of the problem than on being part of the solution. I was tempted to add "leverage" but that's too slippery for a concise discussion. Profits: it took about two years peak-to-trough for profits/GDP to correct during the past two recessions. Unless you see sudden stop risk, this suggests the US corprorate sector isn't staring down the barrel of a massive deleveraging...yet. Politics: public support for legislative non-compromise does not speak to the kinds of policy fixes applied in 2008-9. Executive belligerence toward the Fed doesn't seem helpful either. As much as markets may have appeared to ignore US political risks while momentum was positive, it seems credulous to think this more of a divorce than a separation. There are other quantitative arguments that the turn in the cycle is not here yet (e.g. employment, notwithstanding participation rate). But the prospect of a return to political gridlock is, to me, the most important risk contrast with recent past cycles.

RayVR 8y ago

This is not the typical yield spread a practitioner or the fed would look at.

umeshunni 8y ago
Would they look at 7 and 10 year yield spreads?
- airstrike 8y ago
  I believe the 10- and 2-year yields are most often compared. https://fred.stlouisfed.org/series/T10Y2Y https://fred.stlouisfed.org/series/T10Y2Y

neurobashing 8y ago

Fans of Planet Money’s “The Indicator” are no doubt imagining Cardiff prepping new yield curve material.

vyrotek 8y ago
I immediately thought of this too. Can't wait for the episode.
ric2b 8y ago
Yup, I love that he's so enthusiastic about the yield curve that I was immediately reminded of him when I read the title.

jgalt212 8y ago

It doesn't have to be this way. The curve was unnaturally flat to start with due to Operation Twist. As the Fed unwinds its balance sheet, it seems only naturally to also unwind the effects of Operation Twist at the same time.

apo 8y ago

Worth noting that unlike previous business cycles the Fed is manipulating both the long and short end of the curve. Quantitative Tightening (QT) is the Fed's program to sell and/or let expire the long-term Treasuries it bought during QE 1/2/3. As the same time, the Fed is raising short term interest rates using its tried-and true headline short-term interest rate target. This is not just unusual - it's unprecedented. QT has the effect of suppressing the yield curve inversion signal (by artificially increasing long-term rates). As a result, the gap between the next yield curve inversion (the one mentioned in the article hardly qualifies) and the next recession could be surprisingly short. Backing off now on QT and short term raising, with unemployment at a very low point and inflation ramping up, would be lethal to the Fed's credibility. Whatever Powell says to try to talk the stock market up, he's locked and loaded and can't do much beyond stick with the program: triggering the next recession.

ep103 8y ago
Why can't he slow QT?
- cinquemb 8y ago
  > QT has the effect of suppressing the yield curve inversion signal (by artificially increasing long-term rates) i.e they could, but the long end yields will drop below where they are now, on top of signaling to the market that things are worse than what is admitted if they have to stop.
Jonanin 8y ago
This is a bit alarmist. Please see [1] or [2] for Jerome Powell's thoughts on recent yield curve trends and what it means for the economy. [1] https://www.bondbuyer.com/articles/powell-doesnt-see-high-recession-risk-though-eyeing-yield-curve https://www.bondbuyer.com/articles/powell-doesnt-see-high-re... [2] https://www.youtube.com/watch?v=p7Z46p06WS4 https://www.youtube.com/watch?v=p7Z46p06WS4
Havoc 8y ago
Meanwhile I'm sitting in all cash thinking "Hurry the f up". (Yes yes I know don't time the market)

Tsubasachan 8y ago

All those Princeton and Harvard economists travelling the world telling foreign governments how to run their economy lol. Does any politician in the US even read the emails the Fed sends them? Must be the most thankless job ever.

philjohn 8y ago

Interesting use of the Smiler RollerCoaster in the lead photo. It was involved in a serious crash a few years ago.

ChrisPodlaski 8y ago

Inverted yield curve has predicted 10 of the last 3 recessions

jakelarkin 8y ago
on a 2 year window its pretty accurate. https://fred.stlouisfed.org/series/T10Y2Y https://fred.stlouisfed.org/series/T10Y2Y Max view also true that 2 years a very long time for an economic/investment hypothesis to play out