Inverse Yield Curve: it’s Significance
Government Bonds are the debt securities issued by the government of the countries to assist its spending needs.Generally, the bond issued contains specific coupon rates(interest rate), which differs according to the maturity period(term). Government raise the funds according to its needs with specific maturity date.There are mainly: 2-year, 3-year, 5-year, 10-years bonds in issue.The coupon rate increases with the increase in the duration of the bond(maturing date).10-year bond yields more than the 5-year bond, 5-year bond yield more than the 3-year bond and so on. Like the stock exchange, the bonds can be easily traded through exchange.
When the yield is plotted against the maturing date, we get the normal yield curve as shown in the diagram;
According to ICMA August report, the global bond market was valued at $128.3 trillion dollars whereas, the global stock market capitalization was $87.5 trillion as of August 12,2020(according to bloomberg).The global bond market is approx.46.7% bigger than the global stock market.
Inverse Yield Curve:
Inverse yield curve occurs when the yield(return) on the short term bond is greater than the long term bond.
The phenomenon occurs mainly due to the investor perception and psychology. When the market participants/investor foresees future uncertain,they tend to buy more of the long term bonds as compared to the short term bonds which drives the demand for the long term bond.Also, investors avoid the short term bond which shrinks the demand for the short term bond.
As a general rule of supply and demand,
Long term bond:Demand(↑)and Supply(↓)→Price of bond(↑)& Yield (↓)
Short term bond:Demand(↓) and Supply(↑) Price of bond(↓)&Yield(↑)
Example: Imagine government issued a 10 yr bond with coupon rate of 6% with the face value of $100 per bond and 2 year bond with the coupon rate of 4% is issued at face value of $100 per bond. Both of them are traded at the face value in the money market.In this case,the yield on the 10 year bond is higher than the 2 year bond.
Lets understand how the yield changes when investors anticipate uncertain economic outlook; When investors anticipates the negative outlook of the economy they prefer investing in the long term bond(i.e.10-year) which means that demand surge for the long term bond in-turn, increases the price of that security and is just opposite for the short term bond.
Suppose after a period of time,the 10 -year bond is traded at $120 per bond and the 2-year bond is traded at $70 per bond, which decreases the yield on the 10-year bond and increases the yield on the 2-year bond.The following table summarize the whole scenario;
Significance of Inverse Yield Curve:
Inverse yield curve has been major indicator for signalling upcoming unrest in the economy which might be either economic slowdown or the economic crisis. The occurrence of the inverse yield curve in the last 50 years has always resulted in economic collapse.
The above chart indicates that a recession is followed whenever the yield curve has inverted.The recent yield curve inversion was seen on March 2019, which implies that we were due for an recession or an economic crisis. The recent pandemic driven crisis,which accelerated the crash, was pending as signaled by yield curve.So, it is safe to assume that, when a yield curve inverts the economy might be in trouble as it has success ratio of 100% in predicting the upcoming economic crisis.
In a nutshell, next time we encounter the inverted yield curve ,we must be aware and take precautionary actions to protect our portfolio by using different hedging instruments.