Inverted Yield Curve
Updated On: 03-12-2019
What is a yield curve?
A yield curve shows the relationship between the yield and the time period.
Three types of the yield curve
- Normal yield curve (Upward Sloping)
- Inverted yield curve (Downward sloping)
- Flat yield curve
What does the yield curve tell?
- If the market expects interest rates to rise in the future, yield curve will be normal
- If the market expects interest rates to fall in the future, yield curve will be inverted
- When interest rates are not expected to change, yield curve will be flat
What changes the pattern of the yield curve?
The expectations of borrowers and lenders.
- Borrower: When interest rate is expected to rise, borrowers will issue more long term bond to avoid paying higher rates in the future. The supply of short term bond will decline (Price increase, yield drops) and the supply of long term bond increases (Price decrease, yield rises).
- Lenders: Bond investor will buy short term bond so that when interest rate are higher in the future, they can reinvest in longer term bond to lock in higher rates (Increased demand for short term bond)
- Speculators: Speculators will short longer term bond and buy shorter term bond to profit from it.
The combined action of these 3 groups drive the prices of bond and affects the yield curve.
Why the stock market react so negatively when there is a rate cut?
Throughout the history, when there is an inverted yield curve, a recession is not far away. A rate cut is good for asset price as the required return will be reduced. However, bond investors have expect a bad economy in the near term that requires a rate cut and this is core reason that frightened stock investors.
Besides yield curve, the interest rate spread between different tenure is also important. Why?
A compressing interest spread (narrowing spread) is bad for banks. The role of a bank is to borrow short term money (Eg. 1 year FD from depositors) and lend out long term money (Eg. 30 years house loan). The compressing interest spread is squeezing the profitability of banks as the banks are now charging less for a long term loan.
The interest spread between these two items is called Net Interest Margin (NIM), a ratio that investors will usually monitor closely. Banks are usually the major component in the constituent index of most country. A lower Net interest margin will reduce their profitability and is a drag to the index.
The decreasing yield of long term bond also squeezes the margin of the insurance business. Insurance providers receive premium monthly from the public and invest in safe, long term assets such as long term bond. The diminishing return of long term bond has made insurance premium more expensive as insurance cannot rely on investment income to cover their cost like what they had done 20 years back.