What Is The Yield Curve? Why Is It Important? 2
Before we can answer why the yield curve doesn’t indicate how serious a future recession could be, we need to first understand what the shape of the curve represents.
In normal, non-recessionary times, a yield curve should be sloping upwards. This is simply due to the fact that short term interest rates are normally lower than long term ones.
This comes down to two main factors, namely uncertainty and inflation.
The first is easy to understand, as the longer the time frame, the greater the potential for adverse and unexpected events to occur. Think of it this way, in general, it is more probable that a financial crisis will occur in the next 10 years than it is in the next week.
Simply put, more time on a loan means more time for things to go wrong.
The second factor, inflation, is a bit more difficult to understand, as inflation (or deflation) is an ever present phenomena. That is, inflation is a component of yields at every point in the yield curve.
In other words, inflation is a factor which investors have to consider when purchasing or selling USTs. They expect to be compensated for their expectations of future inflation, and the actions they take come to reflect these expectations in UST yields.
Now, the degree to which inflation matters in yields differs along different points in the curve.
The short end of the curve, typically thought of as yields ranging from the 1 month to 2 year tenors, aren’t as sensitive to inflation expectations as the middle (belly), and long end of the curve.
While it is tempting to immediately jump to the conclusion that an inversion between the 2s and 10s means the market is pricing in higher inflation in 2y yields than the 10s, this would be too reductive.
This is simply due to inflation generally* remaining stable over shorter time frames, but not longer ones.
Inflation tends to only change by small amounts from month to month under normal* circumstances. If traders or investors were looking to purchase a 1 month T Bill, inflation would not be one of their main concerns (if at all).
On the other hand, inflation can and does change by large amounts over years.
This makes longer term UST yields more sensitive to investors’ expectations for inflation. The longer the tenor of the bond, the more sensitive it will be to inflation. Since economies are largely expected to grow over the long term, inflation is also expected to be higher.
Consequently, how the two factors, uncertainty and inflation, change over time helps to give the yield curve its shape.
Short term yields are normally lower than long term ones because uncertainty and inflation tend to be lower in the near future. As uncertainty and inflation increase the further out into the future we go, yields increase in kind.
The result of which is, in normal times, short term yields being lower than long term ones, creating an upward sloping yield curve.
But what about when times are not “normal”?
*Exceptions to “generally” and “normal” would include periods of severe economic shocks, or in the extreme, hyperinflation
To be continued…
Do You Want To Make Money Trading?
Learn how to, and more, in our Trading Courses.