Sunday, June 2, 2019

Yield Curve Inversions and Snow Sleds

Historically an inversion of the yield curve has preceded a recession by about 12 months. So, what is a yield curve? Why does it predict a recession? What does this have to do with snow sleds? Stay with me for a minute, and this will make more sense — first a couple of definitions.

Tedious, but necessary background information - A bond is a fixed income investment where one party, the investor, loans money to another, the bond issuer. Bonds are issued for a fixed period of time. The bond issuer may be a government or a corporation. The bond issuer pays interest to the investor at predetermined intervals and then returns the principal when the bond matures.

A yield curve is an imaginary line connecting the interest rates of bonds maturing at different periods. The term or length of the bond is represented on a number line moving from left to right. Above each point on the number line is the corresponding yield of bonds maturing in that term. A typical yield curve slopes up and to the right as the bonds yield increases with its duration.

Consider a mortgage. The interest rate on a 15-year mortgage is generally less than on a 30-year mortgage. That is because the lender wants more compensation for tying up their money for an extended period. The longer the term of the loan, the higher the possibility that a person may default on the loan. The same is true for bonds. Generally, bond investors require a higher yield to commit funds for more extended periods.

The Inversion - An inversion is where the yield on some shorter-term bonds rises above the yield on some longer-dated bonds. An inversion signals that some investors feel there is more economic uncertainty in the near term than farther in the future. As a result, they require a higher rate of return to invest in bonds maturing sooner than they need for bonds maturing later. A significant inversion in the yield curve for some time, signals a substantial number of investors believe a recession is on the horizon.

The Snow Sled – What could this have to do with a snow sled? Before a snowstorm, the sale of sleds increases. The number of sleds sold is an indication of the confidence people have in the weather forecast. But, the sale of sleds doesn’t dictate the weather. Weather forecasts change, and people prepare for storms that never happen.

The number of investors requiring higher yields on shorter-term bonds indicates their confidence in the forecast of a weakening economy and possibly a subsequent recession, one year out. The purchase of any particular security doesn’t control the economy. The yield curve is just one of many important data points I monitor.