In this series, we break down the jargon and explain a popular investment term or topic. This is the inversion of the yield curve.
A SMALL SIP
Indeed. It’s a bit complicated, but bear with me, as this is a very important and important indicator based on government bond yields. First some basics. Return on investment is the return to the investor from interest payments. Bonds, which are long-term notes that can be bought and sold, often pay a fixed interest rate or “coupon.”
This means that the yield depends on the price of the bond. If you buy a bond with a face value of 100p and a coupon of 10 per cent for 90p, the yield will be around 11 per cent.
But if you buy the bond at 110p, the yield is just over 9 per cent. Prices and yields are inversely related: when a bond’s price falls, its yield rises.
Curve Ball: For the past half century in the US, the inversion of the yield curve has been a surefire signal of impending economic gloom or even recession
WHERE DOES THE CURVE COME FROM?
A yield curve is simply a line on a chart that shows a bond’s yield versus time to maturity.
The yield on short-term bonds is usually lower than on long-term bonds. This is because investors expect higher returns for locking up their money for a decade or more, during which time its value will be reduced by inflation.
Under normal circumstances, when the three-month, two-year, and 10-year bond yields are plotted, the curve should slope upward. But if there is pessimism about the near-term direction of the economy, the yield on long-term bonds could fall closer to the yield on bonds with shorter maturities. This is known as curve inversion.
WHAT DOES THIS INDICATE?
For the past half century in the US, the inversion of the yield curve has been a reliable signal of impending economic gloom or even recession. That’s why the indicator is causing a lot of concern on Wall Street — and has become even more so this summer. The yields on the two-year and 10-year Treasury bills or bonds come under the most scrutiny, which is why New York traders so often talk about “10-2.”
SO WHAT’S GOING ON IN THE US?
Since early July, the 10-2 yield curve inversion has been the deepest in more than 20 years, seen by many as a harbinger of recession, although inflation has cooled slightly. Others disagree, arguing that yield curve inversion no longer serves as a crystal ball.
They say the only consequence of this inversion will be that the US Federal Reserve will be forced to raise interest rates faster than planned. This is puzzling to observers, as the US is technically in a recession. The economy shrank slightly for two quarters in a row.
But banks are healthy, people are spending and 528,000 jobs were added in July, suggesting a recession is not necessarily a foregone conclusion.
SHOULD INVESTORS BE WORRIED?
America is the largest economy in the world. What happens there matters and will be closely watched in the UK. You could even say that the $23 trillion (£19 trillion) US bond market serves as a barometer of the health of the global economy. This week, for example, news that US inflation eased in July was enough to send the FTSE 100 up.
Some analysts focus on cases of yield curve inversions in the government bond or gilt markets in an attempt to determine the length and depth of the recession. But this indicator lacks what one commentator has called the “mythical advantage” of UK policy.
