https://www.financialsamurai.com/understanding-the-yield-curve-a-recession-predictor/
The yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity. A yield curve is almost always upward sloping, a sign that the economy is functioning properly.
To best understand the yield curve, put yourself in the shoes of the lender, the borrower, and the investor. Each entity is rational and looking to do what’s best for their bottom line.
In this post, we’ll look and the yield curve in the past several years. We’ll then discuss how the yield curve acts as a good economic indicator for the future.
Due to inflation, the value of a dollar tomorrow is worth less than the value of a dollar today. Therefore, in order to profitably lend money, you must charge an interest rate. The longer the lending term, the higher the interest you should charge, hence the upward slope of the yield curve.
Let’s say the borrower has a poor credit score and runs an unstable business. Or maybe the borrower has large job gaps in his resume or doesn’t have many assets. If this is the case, you need to charge an even higher rate to account for credit risk. In the situation where the borrower pays back an interest rate higher than your competition, you’re making superior economic returns.
As a bank, your main source of funding is from saving deposits. For the privilege of holding such deposits, you pay customers an interest rate and hope to lend out their deposits at a higher interest rate for a positive net interest margin. If the yield curve is upward sloping, banks have an easier time achieving such profitability.
A rational borrower is incentivized to: 1) borrow as much money, 2) for as long a period of time, 3) at the lowest interest rate possible to get rich. The more you borrow, the more you will likely invest. When the borrowing rate is equal to or below the inflation rate, a borrower is essentially getting a free loan.
The classic borrower example is the homebuyer. After putting down 20%, the buyer borrows the remaining 80%. The lower the interest rate, the more inclined the borrower is to take on more debt to buy a bigger, fancier house. When homebuyers want to stretch, they take out short-term adjustable rate mortgages (ARM) with lower interest rates versus 30-year fixed loans with higher rates. In a declining interest rate environment, taking out an ARM is an optimal move.
In addition to homebuyers, there are companies large and small, that borrow money to grow their respective businesses. If interest rates are lower at every duration, businesses will tend to borrow more, invest more, hire more, and consequently boost GDP growth.
The Investment part of the GDP equation: Y = Consumer Spending + Investment + Government Spending + Net Exports is vital.
Given the motivations of the borrower and the lender, the investor sees the yield curve as an economic indicator. The steeper the yield curve up to a point, the healthier the economy. The flatter the yield curve, the more cause for concern given the borrower’s doubt about the near future.
If there is a lack of demand for short-term bonds, pushing short-term yields higher, perhaps there is doubt about short-term economic growth. Similarly, if investor demand for long-term bonds keeps long-term yields low, this may mean investors don’t believe there are inflationary pressures because the economy isn’t viewed as trending stronger.
Short-term yields are also artificially pushed up by the Federal Reserve since the Fed Funds rate is the overnight lending rate – the shortest of the short. An investor needs to make a calculated guess as to how often and how aggressively the Federal Reserve will raise its Fed Funds rate and how the bond market will react to such moves.
The bond investor wins if inflation comes in below expectations. Inflation comes in below expectations when economic growth comes in below expectations. The stock investor wins if economic growth comes in above expectations, generating stronger corporate earnings growth, while interest rates remain at a level high enough to contain faster-than-expected inflation while not choking off investment growth.