Yield Curve

Bonus Episode: Robert Little: The Yield Curve Is Not Out To Get You

Read the Transcript:

Ben Felix: Rob is a CFA Level III candidate. He has been studying very hard, so I figured he's as qualified as anybody to talk about yield curves right now, while his head's in the books. So Rob, I was thinking maybe you could talk a little bit about what the yield curve is.

Rob Little: Yeah, definitely. So the yield curve is when you're looking at fixed income securities or bonds, it's the relationship between the length of maturity and the interest rate. So if you were to look at this on a graph with maturity length on the X axis, and then the rate on the Y axis, typically what you would see is as you increase the length of the maturity of the bond, the rate you would usually get is higher. So the longer you hold it, you'd usually get a little bit of a premium for holding that for maybe taking a little bit of risk because it's a longer maturity, interest rates could change and possibly a little bit of premium for liquidity as well. And that yield shape can change, it can get steeper and it can get flatter.

Ben Felix: What does a normal yield curve look like?

Rob Little: So a normal yield curve, the longer the maturity is, the higher the rate would be. So at the short end, for a year or less, you'd have a lower rate than what you would hold for two, four, five, six years. So as you get longer in duration, you would expect to hold or receive a higher return.

Ben Felix: So it's an upward sloping chart.

Rob Little: Exactly, yeah. Typically, it is an upward slope, but it can move, it can get flat and it can even invert in some situations.

Ben Felix: So that's what's happening now, the yield curve is, the 2-10 it's called, the 2-10 spread. That's the spread between two year US treasuries and 10 year US treasuries. That spread is very, very small. And when that spread is small, it means we're at a flat yield curve. So the yield on a two year government bond or a treasury and a ten-year treasury, those yields are almost the same right now.

Rob Little: Okay. And is there a reason why you would see a flattening of the yield curve in this situation?

Ben Felix: As with anything, you can try and give an economic explanation, but usually people frame it as it's signaling that the market believes that the prospects for economic growth going forward are relatively low. So, when the short term rate is the same or higher than the long-term rate, it means people don't have a strong economic outlook. And there's some basis for that in history, especially in the US where over the last 60 or so years, nine of the nine recessions, past recessions, in the US have been preceded by an inverted yield curve. So when people worry about it, and when they frame a yield curve inversion as leading to a recession, there's basis for that, because yes, that has happened in the US.

Rob Little: Fair enough. Does the yield curve ever invert and then a recession does not follow that?

Ben Felix: Yeah, it does. Now, in the US and the data that we have available, it hasn't happened, which is one of the reasons people start freaking out when the yield curve gets very close to being inverted like it is now, but it's always tough to look at one single data set and draw a conclusion. So obviously, what we try and do is draw as much data as we can, before we decide that something is robust, I guess, to base any kind of decision on. So when you look at other countries, and Dimensional did a paper on this earlier this year, but when you look at Australia, Germany, Japan, UK, and the US going back to 1985, there have been 14 yield curve inversions. So across all those different countries in total, there've been 14 yield curve inversions since 1985, and they're using the 2-10 spread.

So in each country, they're using the difference between the two year yield and the 10 year yield for government debt in the respective country. And what Dimensional did is they looked at all of those inversions and then looked at the three-year stock market return in the respective country following the yield curve inversion. So in 10 of the 14 inversions, the following three years were positive for the stock market in the local country. So the remaining four, the yield curve inversion did precede a stock market decline. But the majority of instances, when we take a global perspective, the yield curve inversion was actually followed by positive stock market returns. Now, stock market returns aren't necessarily direct reflections of a recession, I guess. So your question was about, does the recession always fall? I don't actually have that data, but are stock market returns always negative after yield curve inversion? The answer is no.

So, that is what it is. And there was a piece from the Federal Reserve Bank of St. Louis that was pretty good, just talking about this exact issue, because everyone's panicking about the flattening of the yield curve. And they recounted the recessions in the US that have been preceded by an inversion, and they actually detailed what the real, well, who knows, I guess, but they pinpointed a macro economic factor that may have caused those recessions, as opposed to just blaming it on the shape of the yield curve.

So they looked at in 1990, there was a recession, which was preceded by an inversion, but they point out that that recession was caused by the Iraqi invasion of Kuwait, which caused a spike in oil prices. And then, they looked at 2001 and 2007 to 2009, which are the more recent two US recessions. And both of those were asset price collapses. So that's the tech bubble, 2000 tech bubble and 07 to 09 was the mortgage backed security and the liquidity crisis. So yes, they're basically saying "Sure, the yield curve inverted it, and there was a recession, but look at this other thing that happened."

Rob Little: There's other factors at play that are making contributions to the recession, not just the yield curve inversion?

Ben Felix: Exactly. Yeah. And they also point out that, what do they say? They say, well, while consumption growth did slow prior to the collapse of the .com asset price bubble in 2000, it grew at a moderate rate entering the recession and accordingly, that was one of the mildest recessions on record. But they're basically saying that the relationship between shape of the yield curve or slope of the yield curve, economic data and stock market data, the relationship's pretty messy. We just happened to have nine instances in the US where there's somewhat of a close relationship between yield curve inversion and economic recession. So that's why everyone starts panicking.

Rob Little: In situations like this, what would you advise to people if they're unsure about what's going to happen? Do you think they just hold on and see what happens? Or what do you think?

Ben Felix: Well, it's the same thing as always. If there were any indicator that were perfect, it would be arbitraged away. It's the same thing as this, and that's actually a really interesting thing with the whole discussion about the yield curve predicting a downturn. If it were a perfect predictor then people would arbitrage it away. It's like, "Okay, we know the market's going to decline because the yield curve is inverted now, so maybe now is a good time people would just buy assets if they knew that's the reasons that assets had declined." Sorry, what was it? What was the question?

Rob Little: I was just saying, if people think this is an indicator of a recession, they're thinking about maybe moving to cash or things like that, which often people do when they think a recession is coming, do you think it's just best to stay in and wait to see what happens?

Ben Felix: You've always got to stay in. Even if, let's make the assumption that the yield curve inversion is going to predict an economic recession, let's just assume that is true. We still don't know when the recession is going to start. So on average, it's been 14 months after the inversion in the US that a recession has started. Now that's on average, but it varies, so you don't know when it's actually going to start. And then, the relationship between a recession and a stock market decline is also not perfect. So there's a great example was the 07, 08 stock market decline where the US yield curve did invert in February, 2006. And following that ,the S&P 500 posted a 14.52% return over the next 12 months. So, yield curve inverts, S&P 500 has a fantastic return.

And then, the yield curve became upward sloping again in June, 2007, which is well in advance of the market's actual downturn, which started in October, 2007 and went through February, 2009. So, there was an inversion and there was a recession, but if you actually tried to use the inversion to time the stock market decline, you would have ended up, well, you would have ended up missing that 14.52% 12 month return of the S&P 500. And if you then got back in when the yield curve was upward sloping again, you would have gotten in at the top, basically the top, right before the crash. So can you use an inverted yield curve to time the market, even if it was a good predictor, which we're not sure it is. The answer is no. So, you just stay invested.

Rob Little: Almost always the best thing is to stay invested?

Ben Felix: For sure. As long as you're in a risk appropriate portfolio, there's no reason to pull the plug, including the shape of the yield curve. So, it's not something that people should stress about, especially you look at the US and it seems so obvious that the yield curve predicts recessions because it has. And there's a lot of data in the US that shows that yeah, that it is a good predictor, but you look at other countries and the relationship falls apart. So, yeah, I don't think it's something that people should stress about. The uncertainty around future market returns is no greater with an inverted yield curve than it is with an upward sloping yield curve. So, if you wanted to get out of the market because you're uncertain about the future, you should have done that six months ago or yesterday, not now because the yield curve is inverted, nothing's changed in terms of uncertainty.

Rob Little: That makes sense. Cool.

Ben Felix: So, that's it. We just wanted to give a little bit of context for our listeners on this thing that's getting a lot of press coverage. Anything else from you, Rob?

Rob Little: No, that was great. Thanks for having me.

Ben Felix: All right. That's it.