Jargon buster: the yield curve

Those who follow fixed income or bond markets closely will often talk about the ‘yield curve’. In short, this is the relationship between short and long-term interest rates. It tells us a lot about where financial markets see an economy going in the future, and in recent months we have seen some significant changes in yield curves right across the world. So, what can these changes point to on the horizon?

The concept of the yield curve is not particularly complicated. It is simply a line showing the yields (or interest rates) of bonds with different maturity dates but the same level of risk.

Typically, the yield curve will be upward sloping. Under normal circumstances, long-term rates are higher than short-term rates as investors demand greater compensation for locking their money up for longer periods of time.

However, when bond investors see lower growth (or a recession) ahead, they begin to factor in, and are comfortable accepting, lower interest rates for longer-term bonds.

This increasing willingness to accept a lower interest rate several years in the future sees longer-term rates fall below the prevailing short-term rate, and the yield curve becomes ‘inverted’, or downward sloping.

Normal and inverted yield curves

Longer-term interest rates are higher than the OCR

Central banks have pushed the interest rates they control to record lows. In New Zealand, this means the Official Cash Rate (OCR) sits at 0.25 per cent.

However, longer-term interest rates that are further along the yield curve have rebounded from where they fell to during the depths of last year. Longer-term interest rates, where the Reserve Bank of New Zealand exhibits less influence (but still some via its quantitative easing programme), sit well above where they did throughout most of last year.

At the same time, interest rates are much lower than they were two years ago, and where they have been historically.

A predictor of recessions

Historically, the yield curve has also been a highly useful predictor of recessions.

When it slopes downwards (or inverts) and longer-term interest rates fall below short-term rates, financial markets are essentially picking that the central bank will need to lower its policy rate in the future.

What sort of environment might necessitate a lower central bank policy rate? This would be during a recession, or at least a downturn in activity.

Bond markets have proven to be a good judge of where an economy (and financial markets) are headed in the future, and the yield curve has an impressive track record of predicting recessions on the horizon.

This is illustrated in the below chart. The shaded areas are US recessions, while the blue line is the 10-year US Treasury yield less the three-month Treasury yield. Of the nine US recessions since 1960, the yield curve has inverted ahead of eight of these.

The yield curve and US recessions

The only time it has not correctly predicted a recession was in 1960. There was also one false alarm, when the yield curve inverted briefly in 1966, although no recession ensued.

Aside from those two examples in the 1960s, the yield curve has a perfect record of predicting all eight recessions since. This includes the COVID-induced recession of last year. When the yield curve inverted in mid-2019, and while its forecasting powers are unlikely to extend to predicting pandemics, it reflected market nervousness over the effect that recent monetary policy tightening might’ve had.

At present, the US yield curve is comfortably upward sloping and is not pointing to any trouble ahead in the immediate future.