THE YIELD CURVE
A global economic recession can be tracked via multiple indicators. The baby boom demographics, the east west cycle, the wealth distribution cycle, house hold debt as a percentage of disposable income, the stock market cycle, the kondratiev wave and the shift in world monetary systems.
All these indicators have peaked and have started to descend. But there is one another indicator that has started making waves and has predicted I think 9/11 recessions in the last 100 years accurately. The Yield Curve.
Here, in this article, I explain to you what exactly is the yield curve and why it has started to flatten out and even invert recently.
First we need to understand what’s a Yield. A yield refers to how much money your money is generating. So basically, the amount of money you make on an investment is a Yield. With that out of the way, lets jump into ‘The Yield Curve’.
We live in a debt based economy which was purposely brought into existence to exert control over the masses. Control, which was not possible via a Gold Backed Economy. So everything the government does, from printing currency into oblivion to issuing bonds is all debt which is backed by ‘Trust in the Government’. But no government is here to last for ever. Or is it? So should you really be trusting the govt?
Anyway, my point is that when the govt can print currency into oblivion, why does it need to borrow from its citizens?
But for this article sake we will assume that the US government cant meet its expenditures and decides to issue bonds worth $500 and $1000 for a period of 2 years and 10 years, respectively. A bond is a certificate which is given to the lender against the money borrowed which basically states that the borrower, which is the US government in this case, will return the lender after a specified period, the principal it borrowed and will continue to pay interest on that principal every year till maturity.
Now when these bonds are issued, the yield curve looks something like this:
On the X axis, you have maturity years which could range from 1 month to 20 years. On the Y axis, you have the Yield percentage. Higher the maturity years, higher the yield percentage. So a normal yield curve or a upward yield curve is the one which has low interest rate on short term bonds and higher interest rates in long term bonds. Trace these lines and you will see a upward yield curve as seen below:
Bear in mind that bonds can be of numerous type but the one that defines the Yield Curve are the U.S Treasury Bonds.
Now before we proceed, we need to understand what defines the yield percentage. Yield is a function of coupon and market price.
This means, two factors determine the yield percentage i.e. coupon payment which is based on the FED’s interest rate and the market price which is determined by the free market. These bonds can also be sold in the free market for a profit or a loss. Here’s how that happens.
Most people don’t buy bonds from the government. They buy and sell them from each other i.e. in the secondary market. And the prices change based on how much demand there is for the bond. Now here’s where things get more complicated. Lets say you are an investor and you have a hunch that a economic downturn is coming in the near future. If your hunch is correct, that means if you buy a short term bond, lets say a 2 year bond, you might get your money back in a bad economy and there might not be anything good to invest in. That makes a 2 year bond a lot less attractive to you. And if a lot of investors think this way, then the demand for the 2 year bond plummets and it starts selling for cheaper. But because the 2 year bond now costs less, it yields a lot more relative to that low cost. At the same time, investors who think a economic downturn is coming might think, I’d rather invest in a longer term bond, lets say a 10 year bond that pays out way later, when I think the economic downturn will be over. So that bond get more popular. But it also get more expensive. So investors start yielding less money as they have to pay more for a bond of a fixed monetary value and a yield percentage. And if enough investors are acting on this expectations, then the yield on the long term bond, which is always higher than the short term bond, dips lower.
As you can see in the above image, the yield curve has now inverted since the yield on the short term bond rose and that on the longer one fell. In other words, when the yield curve looks like this:
The investors think an economic downturn is probably around the corner.
And as I write this article on 07/04/22, the yield curve inverted but went back to flat. So is a recession looming around? Not necessarily. But when a see all the years on a single screen:
Its pretty safe to say, when the yield curve inverts…………….. Its not a good sign.
