Bitcoin Market Intelligence - Issue #18 - Yield curve inversion, monetary policy and markets (Published: December 13, 2022 on Revue)
Note: This is an old issue which has originally been published on Revue on December 13, 2022
Hey,
today I am writing about government bonds, bond yields and, particularly, inverted yield curves in the US and what this means. I will start with the basics, what a government bond is, bond prices, and how bond yields are derived, as these can sometimes be counterintuitive.
If you are familiar with these concepts, feel free to skip those parts of the newsletter.
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What are government bonds?
Government bonds, also known as sovereign bonds, are debt securities issued by national governments to raise funds to finance their operations. These bonds are typically issued with a fixed interest rate and a maturity date, at which point the principal amount borrowed must be repaid. Investors who purchase government bonds are essentially lending money to the government, and in return, the government agrees to pay them regular interest payments until the bond matures. Government bonds are considered to be relatively safe investments. Due to this, the interest rates on government bonds are often lower than those of other types of bonds, such as corporate bonds.
How are yields on government bonds calculated?
The yield on government bonds is the return that investors receive on their investment in the form of regular interest payments. This yield is expressed as a percentage of the bond’s face value, which is the amount that will be repaid to the investor when the bond matures. Let’s take, for example, a 10-year bond that is issued at a value of $1000 with a 10% percent annual interest rate. This means that the bondholder receives $100 each year plus the $1000 at the date of maturity. This bond can now be traded on the market, e.g., at $800. Regardless of the value it is traded at, you will still get the interest payment of $100. So if you buy that bond on the market at $800, the yield you get on your investment will be higher than the 10% at 12.5%.
What is the yield curve?
The yield curve is a graph that shows the relationship between yields on bonds with different maturities. You can, for example, have government bonds that mature after a few months or years. A yield curve is a useful tool for investors and analysts because it provides insight into the current state of the bond market and can be used to make predictions about future interest rates.
The yield curve is inverted. What does this mean?
If the yield curve is inverted, this means that yields on bonds with shorter maturities are higher than those with longer maturities. This is the opposite of a normal yield curve, in which yields on bonds with longer maturities are higher than those with shorter maturities. Investors generally expect a higher rate on longer maturities as, e.g. uncertainty regarding prices in the long term is higher than in the short term, and thus there is a “premium” in the longer-dated bonds.
When the yield curve inverts, this means that, e.g. demand for long-term bonds is rising faster than for short-term bonds or falls less fast. Remember, a rising value in a bond means a fall in yields.
The curve may invert if investors shift towards long-term bonds due to the expectation of rising risk in financial markets in the near term.
So an inverted yield curve is considered a sign of a potential recession. This can happen for several reasons, such as a slowdown in economic growth. It is important to note that an inverted yield curve is not a sure sign of a recession, but historically it was a strong predictor of one. The yield curve inversion itself is not what is causing the recession, but it is a sign of how investors see the economy developing over time.
The 10-year to 2-year yield curve inversion and Fed monetary policy
Here I am focusing on the 10-year to 2-year yield curve. Some may argue that shorter-dated bonds should be looked at, Fed officials in particular. But as the 10-year to 2-year yield curve is used by many market participants, I will focus on that one.
Once the US yield curve inverts, it takes the FED some time to cave; to lower interest rates again.
In the latest history, that reaction window lengthened by quite a bit.
Below are the weeks it took until the interest rate peaked. Going forward, if I am referring to the peak or top, I mean the end point where interest rates were still high before the Fed started lowering them again.
02. January 1989 - 29. May 1989:
21 weeks + rate hikes
31. January 2000 - 27. November 2000:
43 weeks + rate hikes
05. June 2006 - 03. September 2007:
72 weeks + rate hike
Graph 1: 10-year to 2-year yield curve and Fed interest rate (Source: Tradingview)
We are currently 23 weeks into the yield inversion and have yet to see the Fed showing signs that they intend to pivot. Considering that year-over-year inflation in the US is still at 7.1% for November, that likely is still some time away. Even if inflation has slowed a bit recently (October 7.7%).
If history is a guide, the Fed will hike a few more times and then keep the interest rate at that higher level for a prolonged time before lowering it again (this is also what is being communicated by the Fed: slower rate hikes, but also potentially a longer period of a high level of interest rates than originally anticipated). Tomorrow (Wednesday), the Fed is expected to hike by 50bps after a sequence of 75bps hikes. Markets are currently pricing in the 50bps hike at 80%.
Just going by the graph, the period of interest rates at a high level without further hikes has also lengthened after the yield curve inversion.
Note: Particularly in 2006, it is hard to pinpoint the exact time of the yield curve inversion as it hovered below but close to zero for some time and even went slightly above zero at times.
If you are strict and only take the weeks it has been fully inverted, you end up with:
14. August 2006 - 03. September 2007
63 weeks; no hike
This is still longer than the previous two times.
So do not take the exact weeks too literally, and use them more to get an idea of the duration of these periods.
Yield curve inversion and financial markets
What does this mean for financial markets? In the following graphs, the yield curve and the S&P 500 are shown zoomed in to the above-marked yield curve inversions. Does the inverted yield curve signalling recession mean more pain for financial markets? Not necessarily.
In 1989 we saw the S&P 500 rise after the curve inverted and even after the Fed did start lowering rates. It took until July 1990 that the market started to correct. The US entered a recession in Q3 in 1990, matching that decline in the S&P 500.
In 2000 at first, we saw the S&P 500 rise, but it also started declining before the Fed started to pivot on interest rates. The recession started in Q2 2001, so the S&P started to fall well before the US was officially in a recession.
In 2006 the S&P 500 did also mostly rise before the interest rate levelled out and started to decline again. Briefly, after that, the S&P 500 also started to decline.
Graph 2: 10-year to 2-year yield curve and S&P 500 around 1989 (Source: Tradingview)
Graph 3: 10-year to 2-year yield curve and S&P 500 around 2000 (Source: Tradingview)
Graph 4: 10-year to 2-year yield curve and S&P 500 around 2006 (Source: Tradingview)
Graph 5: Recessions and GDP (Source: St. Louis Fed)
How does today compare?
Compared to the previous three times, markets already started to decline before the curve inverted. Since the curve inverted, the S&P 500 has been moving up and down a bit, but all-in-all has been more or less flat until now..
Graph 4: 10-year to 2-year yield curve and S&P 500 today (Source: Tradingview)
Does that mean it is up only from here, particularly once the Fed pivots? No. Looking at past events, the Fed pivot is not immediately bullish for financial markets. They may pivot if something breaks in the economy, e.g. when it slides into a recession. At least in the short term, this is not bullish for financial assets. Particularly if we go by the dot-com bubble around the early 2000s and the global financial crisis in 2007-2008.
While history never repeats itself, it does often rhyme. So the study of previous crises can help us make some educated guesses on where markets may be headed.
In the end, only time will tell.
The end of the year is approaching fast. So this will be the last issue of the newsletter for this year. The next issue will be sent out at the beginning of next year.
I wish you a peaceful Christmas holiday and a Happy New Year!
Next year is going to be great!
Jan Wüstenfeld
If you found this newsletter insightful, don’t forget to subscribe and share it. You would make my day! :-)
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This content is for educational purposes only. It does not constitute trading advice. Past performance does not indicate future results. Do not invest more than you can afford to lose. The author of this article may hold assets mentioned in the piece.