About a month ago you might have come across the finance sections of your news feed freaking out about an “inverted yield curve.” This means 2 things: one, the present article is well overdue and two, it’s not at all unreasonable to expect bearish market forecasts (pessimistic market sentiment, causing asset prices to fall) over the coming weeks. Today we’re going to talk about what exactly the inverted yield curve refers to and its implications for the economy as a whole.
Bonds and their yield curve
So let’s get some basics down first. The idea of bonds is rather straightforward - they are highly transferable loans wherein the ownership is bought and sold between individuals, businesses, and governments. A bond’s yield curve shows the percent return a given investor can expect to make over various periods of time. This information is imperative when attempting to value the bond as not all of them have the same maturity (when the bond is to be paid back in full) - it can range from 30 days to 30 years.
A bond’s yield increases in congruence with its maturity (when the bond is to be paid back in full) meaning the further the due date is for the debt to be disbursed, the higher the bond’s yield is. Why? Because it rewards the more patient investors. If you lend someone $1000 that’s to be paid back in a year, that’s a whole 365 days of you not having that $1000. You could have used that money to buy yourself something and enjoy it now, but you didn’t - you forgo your consumption which in turn gave the borrowing end of the bond access to funds that they presumably require. So in other words, yes, good things do indeed come to those who wait.
This principle of longer maturity = higher yield also applies to government bonds (in the case of the US, bonds issued by the Treasury or T-bonds). Historically speaking, for example, a 10-year T-bond had higher yields than a 2-year T-bond:
Generally speaking, the short term yields are made up of which policies investors expect the central bank to implement in the near future, especially in regards to the overnight interest rates. High short term yields mean investors expect the central bank to raise rates in the near future, since with higher interest rates, investors choose to tie up their money in interbank lending versus the government bonds, as it offers better returns. As such, the lower demand for the bonds lowers the bonds’ price - but this increases the bond yield because the amount of money an investor receives doesn’t change.
Say the government is issuing a 2-year $100 bond with a $2 return (2% yield) and the central bank interest rates are currently 0.5%. In this scenario, investors would receive more money from investing in government bonds than they would from interbank lending, and so that’s what they do. The demand and consequently the price for 2-year bonds skyrocket, which in turn means that the yield goes down. Thus low short term yields means investors expect interest rates to either remain low or be lowered in the near future.
The inverse is also true - say the government issues a 2-year $100 bond with a $2 return (2% yield) and the central bank interest rates are currently 5%. As such, investors flock to interbank lending activities in order to acquire that 5% return on investment. This lowers the bond prices to say $70 which increases it yield - instead of it being 2% ($2 / $100), it’s now around 2.9% ($2 / $70). It’s extremely important to keep in mind that the amount of money a bond investor receives doesn’t change - that’s why higher bond prices mean lower yield and vice versa.
Long term yields operate via similar mechanisms but are reflective of slightly different things. Low long term yields mean investors expect low inflation and low interest rates; the bond investor need not be compensated for rising prices and, as shown above, a lower interest rate means a lower bond yield. High long term bond yields mean investors expect interest rates in the long term will rise (higher interest rates means more people will turn to interbank lending as an investment option, thus decreasing bond prices, thus increasing the yield), which are typically done so to clamp down on inflation - as is the case at the time of writing.
The inversion
The chart above shows the 10-year bond yield dropping below the 2-year bond yield - which isn’t supposed to happen under normal conditions, since it means that those who are giving up some money for only 2 years are now obtaining better returns than those giving up some money for 10 years. It’s not at all uncommon for long term bond yields to go down in the wake of declining inflation expectations (as explained previously), but alarm bells tend to go off when it’s more profitable to cash in on 2 year bonds as opposed to 10 year ones.
The prevailing theory for why this has happened is that investors have lost faith in the stock market and are shifting their funds to safer assets such as government bonds, the long-term ones especially since locking in their position for a longer period of time will keep that money safe in the event of a recession. If people feel that their returns from a T-bond will exceed their returns from the stock market, then it’s safe to assume bearish markets. But this is just one potential reason we see an inverse to begin with and therein lies perhaps the most important point: an inverted yield curve does not necessarily mean a recession is imminent. The damage that did end up emerging from this (Wall Street went through a huge sell-off upon learning of the inversion) was largely because of a cycle of investors jumping to conclusions of how other investors reacted to this news: “Oh look, the yield curve just inverted. This must mean that other people’s stocks are doing badly, which means they’ll start selling their shares, which means my shares will start going down, too! I better cut my losses while I still can.”
Econ IRL
Of the many proposed ways to reduce greenhouse gas emissions, one that may be receiving less attention than it should be is mandating that power plants disclose their CO2 output. This week’s paper studies the Greenhouse Gas Reporting Program to find out whether such a policy would actually help in reducing emissions. This report mandates that all power plants who produce more than 25,000 tons of carbon dioxide each year communicate their emissions to regulators who will then make this information public.
The researchers found that the power plants going through heavier federal investigation into this matter reduced their CO2 emission rates by 7& and that the largest public firms reduced theirs by 11%, the latter of which in particular could be attributed to stockholder pressure. Furthermore, major emitters were also 55 percent more likely to switch to cleaner fuels than those unaffected by the transparency-mandating regulations.
‘Till next time,
SoBasically