Yield Curves explained – Is the US Yield Curve Predicting a recession?

What are yield curves and what are they telling us?

The US Fed started its monetary tightening journey, as expected by markets. Something interesting is the impact this decision has had on the yield curves.

What is the yield curve?

A plot between the Yield to Maturity and Tenure of bonds, by the same issuer. For our discussion , we will use the US government bonds yield curve, which has seen a fair bit of action in the past few months.

For our understanding, we will assume the shorter end of the curve to be represented by 2 year bond yields, and longer end by 10 year bond yields. So, there are three ways, the yield curve can move.

The first one is a parallel up move or a down move in which your shorter end of the curve and the longer end of the curve, both move upwards by an equal amount. In other words, the two-year yield and the 10-year yield could both move up or down by a similar amount. This signifies that the market is expecting rates to go up, but there is a uniform expectation across the yield curve. So you’re assuming that while rates will go up in the short run, they will also have to remain high in the longer runs to as to so as to control the inflation and the growth in the longer run. Usually, risk assets such as equities would view this as neutral in the short to medium term.

The second way it can move is if the shorter end yield does not move, but the longer end goes up. This would appear that the yield curve has steepened – with 10 year yields going up more than 2 year yields. This means that the economy is growing, inflation is heating up and in the longer run, you will have to increase rates, but there’s no immediate pressure to raise rates. For risk assets like equities, this is actually considered positive, since it is growth that is pushing up inflation.

The third way is that the shorter end goes up, but the 10-year yield does not go up as much or does not go up at all. In this case, commonly called as the curve flattening, your expectations from the market are that in the near term rates will have to rise, but in the longer run that would result in slowing growth. And so, the rates will have to be cut again. This kind of movement is a precursor to a flat or inverted yield curve. Inverted yield curves historically have been a good predictor of recessions. As a result, equities usually do not like this scenario.

 

How has the US Yield curve moved in the recent past?

What we are seeing in the US market right now is this third kind of move. 2 year yields have gone up significantly, whereas 10 year yields have not moved up as much. The difference between the 2 year yield and the 10-year yield was roughly about 125 basis points in the month of October 2021. It has now gone down to about 20 basis points as we as we write this.

This indicates that bond markets are pricing in that the US Fed will raise rates aggressively this year. They mentioned this in their announcement on 16th March. However, that would probably result in slowing growth in future. If inflation continues to remain high, this could result in Stagflation (Stagnation and Inflation).

We will know in a few days if the Bond Markets are correct in predicting this. What do you think – between Equity and Bond markets, which markets are correct?

 

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Mutual Fund Penetration of various countries: View it here

 

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