Why is the yield curve inversion only a warning?


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Arthur Idiatulin
Arthur Idiatulin added a new post
3 years ago

Inversion of the US yield curve continues, becomes stronger and captures more and more sections of the curve, but why is this just a warning, not a sign of recession?

Because the inverted curve should be followed by the steepness (return of positive spread between the long and short maturity bonds) and only then, based on historical experience, we can begin to trumpet about recession.

To understand why, it is useful to first consider the causes of the inversion curve. For simplicity, consider the choice of two investment alternatives for an investor for an investment period of 5 years:

Buy and reinvest in 1-year zero-coupon bonds 5 times (in total the investment period is 5 years)
Buy a 5-year zero-coupon bond and wait for the maturity date.

In both cases, the return from the strategies in 5 years is compared.

In the case of the first strategy, only the rate for the first year is known, all subsequent rates are expected (i.e. they are forward rates). In the second strategy, the 5-year rate is now known.

The no-arbitrage condition tells us that the expected return from both strategies should be equal, i.e .:

Roughly speaking, this expression tells us that in order to calculate the spot rate of a 5-year bond, you now need to know the current 1-year rate and 4 subsequent forward rates. Of course, it is necessary to make the statement that, on average, the forward rate correctly predicts future spot rates (“is an unbiased estimate of future spot rates,” statistics will say).

If expectations are formed in the market that future rates will decrease (forward rates will react downwards), in the right-hand side, the 5-year rate will also decrease. Since the price is inversely related to the rate, this means that demand for the long-term instrument is growing. At the same time, investors holding a 1-year bond may prefer to sell it and invest immediately in a 5-year bond. This will lead to the fact that the price of a one-year bond will decrease (its yield will rise), and yield of 5-year bond will decrease. If such a trend will be strongly pronounced, then the inversion of the yield curve will occur.

it is extremely easy to get confused in terms of “interest rate” and “yield” (even without realizing it), since in one context they are interchangeable concepts, but not in the other. In addition, the meaning invested in these concepts may also depend on the context. In a general sense, the interest rate is the opportunity cost of capital (loss of profit from “not investing” in the best alternative in the market) for a given level of risk and period of investment. The convenience of formulating through alternative cost is such that when determining the attractiveness of a particular investment, it is necessary to compare it with “what the market offers for the same money.”

Yield curve – interest rates for zero-coupon bonds, which are calculated on the basis of trading activity every day using special formulas (for example, the Nelson-Siegel parametric curve, in the case of the Moscow Exchange). Yield to maturity (internal rate of return) is an indicative rate at which all future payments on the bond, including par, are discounted.

In the case of bonds, the rate is always meant exactly the current yield to maturity.

But why is the inversion of the yield curve still not a sign of imminent recession? Historical examples show the following:

As can be seen, in the three previous cases of recessions in the United States, they were accompanied by a sharp return of the positive spread between long-term and short-term Treasuries, i.e., the transition of the yield curve from inversion to the “normal” form. Now we are approaching the point after which what happened before can occur – the return of a positive spread. That’s when you should start worrying.

Why so? We will try to figure this out in the next article.

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