Yield Curve Inversion – Mar 22, 2019

by | Mar 25, 2019 | Learning Module 2, Topic 2: GSEC's and Corporate Bonds | 0 comments

Whenever I introduce yield curves in the classroom, it has become a habit to say something like “equities are for sissies, bonds are where the big girls play!”. Even an e-mail service that I have less and less time to read, echoed this sentiment today with, “it’s like the school playground, where the yield curve is the ‘cool kid’ and equities are the followers.” The full story is here. In their reproduced chart below, the red line is the difference between the 10-year yield and the 3-month yield, which by about 12:00 noon was negative by 3 basis points. And the blue line (S&P 500) tagged along.

 

 

 

 

 

 

Q: What is the yield curve?

It represents the rate of return earned (by lenders) and paid (by borrowers) for different time horizons.  For lenders, it is reasonable to expect higher interest rates when you lend money for longer periods of time. In geek-speak this is liquidity preference. Likewise, borrowers are willing to pay those higher long-term rates when they are confident of future economic prospects. So the typical yield curve slopes upwards. What is being shown on the plot above is the difference in yield between the 10-year and the 3-month instruments. For a historical look at how the yield curve for US treasuries bounces around, click here.

Q: What is an inversion of the yield curve?

It simply means that short-term interest rates have moved higher than long-term rates. If borrowers are uncertain about the future, they may even be willing to pay more for short-term debt instruments, causing short-term interest rates to rise, relative to long-term ones. As short-term rates rose, (the difference between the two, also known as the spread, shrinks).

Q: How big is this difference?

It is typically measured in basis points (bps or “bips”) which is 0.01% or one-hundredths of 1%. Before US markets opened, as the graph shows, this spread had dropped from 7 bps to almost 0 bps, equity futures were dropping sharply and continued that trend after the equity markets opened for trading, calming down only when interest rates did (12:00 pm).  

Q: Why is this a big deal?

The reason markets freaked is because the last time this happened was in 2007 just before the global financial crisis. Short-term liquidity issues at a big financial institution were the cause then, and, I suspect fears of a recurrence now.

 

 

 

 

 

 

 

 

 

 

Q:  How do banks fit into this?

Banks typically borrow short-term (your deposits) and lend long-term (loans, housing). And live happily on the difference (net interest margin). When the two rates converge, (i.e the yield curve flattens) bank profitability can suffer, hence the pressure on bank stocks.

As with most things economic, there are multiple factors at work simultaneously. Overnight borrowing and lending takes place in the banking system daily. For instance, one brokerage house may end up owning a lot of securities (acquired on behalf of their customers) at the end of one day and another with a lot of cash. The latter can then lend the securities to the former for some of that cash while agreeing to buy it back the next day. (This is the overnight repo “repurchase” market.). If an institution for whatever reason is seen as less likely to repay, then that short-term rates jumps!

Q: How is this relevant for India?

In India, the yield curve for maturities is currently flat meaning that after 3-years, there is very little difference between the rates available for increasingly longer maturities. Part of this has to with the fact that bond markets are not yet very developed in India.  However, there has been a steady stream of economic data pointing to slowdowns in Germany and Japan, contraction in manufacturing activity in France, the never-ending Brexit issue and the just-ended Trump-Russia investigation that spooks global investors and affecting money flows into Indian markets.