How to interpret the inverted yield curve in the US bond markets
Over the last few days, there has been a lot of debate in the public domain about the US yield curve taking on an inverted shape. This is not a normal occurrence and is being interpreted in the market as a signal of an impending slowdown in the global economy. Is it a cause for concern and what does an inverted yield curve really mean?
About yield curve economics
The yield curve measures the relation between term to maturity and the yield. The normal argument, and rightly so, is that longer the tenure, greater is the risk. Hence long maturity bonds tend to trade at higher yields than shorter maturity bonds. An inverted yield curve does not mean that the shape of the yield curve is inverted. What it means is that the yield on the 10-year bond or the yield on the 5-year bond has fallen below the yields on the 2-year bond. In the last few days, we did see the 10-year US bond yields dipping to below 1.55% and in the process going below the 2-year bond yields. This is not the first time that this has been noticed but we have got to see this at least 4-5 times in the last one year. When long term yields go below short term yields, it is an indication about caution among bond investors to take a long term view. This is seen as indicative of an impending economic slowdown. In the past, such inversions have led to a full-fledged economic slowdown in at least 80% of the cases. That is the worry!
How to read the yield signals
An inversion in the yield curve, by itself, does not imply an economic slowdown. It is only when the inversion is backed by macro data that markets tend to get worried. Currently, there is a trade war on between the US and China and that has putting visible pressure on global growth. IMF has already sliced off 40 bps from growth estimates. The bigger worry is the limitations of monetary policy. In the last 10 years since the 2008 Lehman crisis, central banks across the world have gone on a spree cutting rates and infusing liquidity. There is not much scope left for these central banks to give a further boost to growth via monetary incentives. That is one of the key reasons why the inverted yield curve has resulted in fears of an economic slowdown across the world.
What the inverted yield curve may be reflecting at this point of time are two anomalous events. For the first time in history, there are bonds worth $17 trillion earning negative yields. This time around, negative yield has become a central bank strategy. That is because central banks find it the best defence against being drawn into a currency war. When yields are negative, flows will be limited and currencies cannot strengthen. So, any currency war will be ineffective to begin with. We are surely in for some interesting times!