US Inverted Yield Curve: Part I - Explaining the Yield Curve

Updated: Apr 4, 2019

by InvestCEE Staff, Chris Ball

Link here to Part II - The Inversion and What It Means

Link here to Part III - Implications for CEE Economies

Photo by Mathilda Khoo on Unsplash

There's a lot of talk today in the US about the Inverted Yield curve in the US bond market. I've been getting a lot of requests for me to explain what the yield curve is, whether its inversion means a US recession is coming and then what that would mean for the world economy. So I thought I'd take a minute to address this through InvestCEE and focus on the implications of the yield curve and its inversion for the CEE region in particular.

I'm an academic economist, not a stock or bond trader. I'm not offering any trading advice, just insight and understanding - I hope. Use it as you see fit and I wish you many happy returns.

The first question of course is what is the yield curve. Yields are returns on investments. And we generally just think of them as "interest rates" which are the returns on investments, or, in other words, "yields". Investments generally have a time component to them. Short term investments of, say, 3 months, pay a different returns (yields), than long-term investments of, say, 10 years.

The yield curve is just a plot of these yields for the same investment but at different times or at different lengths of time. That is, a yield curve plots the return (yield) on a 3-month bond, on a 1 year bond, a 2 year bond, and so on. A very common bond to consider is a US Treasury bond.

If you looked this time last year, March 2018, at the yields on US Treasuries you would have found the following:

Source: FRED, Federal Reserve Bank of St. Louis and author's own calculation

This data reflects a "normal yield" profile, or normal data behind a yield curve. It is clear that the yield on short term US Treasury is lower than on longer-term US Treasuries. If these were the interest rates on a car or home loan, then it says that the interest charged on a 30 year loan costs more than a 1 year loan. This is the normal pattern: higher interest rates (yields) for longer-maturity loans or investments.

These data generate the following "normal yield curve" which is how the world looked in March 2018.

Source: FRED, Federal Reserve Bank of St. Louis and author's own calculation

There are three key things to keep in mind when looking at yield curves:

  1. First, the price of bonds and the yield on bonds are inversely related. That is, when the price of the US Treasury goes up, the interest rate on that Treasury goes down and vice versa. This is important because when demand goes up for bonds, it pushes up their price and down their yield which can be kind of counter-intuitive at first glance. So, keep in mind: higher demand for a bond pushes up its price and down its yield while lower demand lowers its price and raises its yield.

  2. Second, in general, lending longer term is riskier so you need higher interest rates to compensate lenders for risk which is why banks charge higher rates when you want a longer term loan. The same is true here. Very little that is unforeseen can go wrong in one month but in 1 year more can go wrong. So investors require higher yields to lend/invest 1 year. In 10 years anything can happen! So investors require even higher yields still. For this reason, yields are generally higher for longer horizons. And for this reason, the yield curve normally rises (i.e., is upward sloping). NOTE: To tie it back to point 1, because longer maturities are more risky, demand for those bonds will also be less so their prices will be lower and their yields higher since the price of bonds and their yields are inversely related.

  3. Third, the yields on bonds are interest rates. And there are two important things here about interest rates: (1) they tend to move together in general, and (2) they tend to move up and down with inflation.

  • The first point matters because the US monetary authority, the FED, sets "the economy's base rate" called the federal funds rate. And the FED will increase that rate to slow the economy and lower that rate to stimulate the economy. Since interest rates move together, if the FED increased interest rates today and held them constant, it would just shift the whole yield curve up a little. But if instead everyone today believes the FED will raise rates next year, then it will raise all the yields on the yield curve starting in 1 year. If everyone believes the FED will lower rates next year, then the yields will all decline starting 1 year.

  • Likewise for the second point. If inflation goes up and stays up from now on, the whole yield curve will rise. If everyone believes inflation will rise in 2 years, then the curve will rise up from year 2 onward. If they believe inflation will fall in 2 years, then the curve will lower from year 2 onward.

  • As a final note here, the FED will raise interest rates to fight higher inflation and lower interest rates when inflation slows, so these two points get intermingled in practice.

To conclude this introduction to the yield curve, the yield curve is normally rising. Longer-term rates are generally higher because longer-term investments are riskier, requiring higher returns to attract investors (and because they are riskier there is lower demand, pushing down prices and up yields). The FED can also move interest rates and this will move either the whole yield curve or only specific yields depending on when everyone thinks the FED will change interest rates. And interest rates will rise and fall naturally as inflation rises and falls. Again, this can move the whole yield curve or only specific yields depending on everyone's expectations about when inflation will rise or fall.

Next we'll look at the Inverted Yield Curve and what it means.

About the author

Chris Ball, PhD is the co-founder and advisor for InvestCEE. Chris serves as the Honorary Hungarian Consul for Connecticut, the executive director of the Central European Institute and the István Széchenyi Chair in International Economics at Quinnipiac University.