Understanding the Yield Curve
Summary: Rieger Report contributor Peak Capital Management provides their insights into the yield curve as we enter 2019.
Author: Clint Pekrul, CFA, Peak Capital Management Head of Research
Much has been made recently about the possibility of an inverted yield curve, and what an inversion would mean for financial markets. We thought it would be helpful to explain what an inverted yield curve means, and how it might impact the prices of financial assets.
For starters, the yield curve basically describes the interest rates on U.S. government debt for a range of various maturities. For example, the U.S. Treasury issues debt that matures in a fairly short period of time and debt that matures several years down the road. The Treasury issues this debt to finance the U.S. government. Treasury bills mature generally in less than one year, while Treasury bonds can mature 10 to 30 years in the future.
Generally, Treasury bonds will carry a higher rate of interest than Treasury bills for the simple reason that holding a bond carries more risk. The further you go out into the future, the more uncertain your rate of return becomes. In order to entice investors to buy its debt, the Treasury will generally have to compensate investors with a higher rate of interest. This is why Treasury bonds normally carry a higher rate of interest, or coupon payment, than Treasury bills.
If you were to plot the interest rates across all the various maturities, it would form a curve (hence the term “yield curve”). The result is generally a curve that is upward sloping (i.e. lower interest rates for Treasury bills and higher rates for Treasury bonds). An upward sloping curve has many ramifications for the financial markets. The interest charged on debt is directly pegged to the Treasury yield curve. For example, the interest rate you pay on your mortgage or auto loan is to some degree tied directly the interest rate on Treasury securities. The reason is that Treasuries are considered risk free from a credit standpoint. That is, there is little to no likelihood that the U.S. government will fail to repay the principal on the debt it issues. Therefore, Treasury yields represent the “base-line” rate.
Yields on other debt (e.g. mortgages, corporate bonds, etc.) will carry a higher rate than Treasuries because of credit risk. That is, a consumer or corporation does not have the same creditworthiness as the U.S. government. The point is that interest rates across the global debt market are inextricably linked to the Treasury yield curve, which emphasizes the importance of the shape of the yield curve.
In order for banks to be profitable, they must charge a higher rate on the loans they make than the rate they must pay on deposits. This differential, or the spread between the interest collected on loans and the interest paid on short -term deposits, largely determines a bank’s profitability. Under normal conditions, an upward sloping yield curve will encourage banks to lend, which in turn drives economic activity. However, there are circumstances where the yield curve becomes flat or inverted.
A flat yield curve implies that short-term interest rates are identical to long-term interest rates. When this happens, banks can become less profitable. The interest banks pay out on deposits isn’t much different than the interest they collect on loans. Lending activity can diminish under these circumstances. What’s worse for banks is when the yield curve inverts. This implies that the interest banks pay on deposits exceeds the interest they collect on loans. As a consequence, the bank’s profit margins can come under pressure. Lending activity can dry up considerably and the economy can slip into a recession.
The fear of a recession is prevalent today. The Federal Reserve, which sets short-term interest rates, has been increasing its target rate. However, the longer end of the yield curve, which the Federal Reserve does not control, has not moved much. As a result, the yield curve has flattened recently. The concern is that the yield curve might actually invert, which historically been a precursor to a recession.
If we indeed go into a recession, it would mark the end of an incredibly long expansion coming off the financial crisis of 2008-2009. Despite evidence that the economy, particularly in the U.S., is on firm ground (unemployment is low and GDP is expanding at an acceptable pace), global forces might hold down long-term rates while the Federal Reserve bumps up the short end of the yield curve. Critics would likely blame such a recession on a monetary policy error. In the meantime, we’ll have to wait and see how things play out.
Date of publication: January 9, 2019
This material is for general information and education purposes. The information contained in this report represents the opinions of Peak Capital Management, LLC, as of the report date and does not constitute investment advice or an offer to provide investment management services. Before purchasing any investment, a prospective investor should consult with its own investment, accounting, legal and tax advisers to evaluate independently the risks, consequences and suitability of any investment.
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