Why do shifts in the yield curve matter?

Bond markets, albeit partly dictated by investor sentiment, at times irrational, often provide a forward-looking view shedding light on the economic climate. Economic factors which typically impact sovereign yields and thus the yield curve include; interest rates, inflation, and economic growth. Such impact is intertwined.

Inflation, consequent to a collective response to the pandemic by both monetary politicians and governments, supply chain issues, and recent geopolitical tensions - further exacerbating the situation - rose to record levels eroding household’s purchasing power. Monetary politicians countered, despite the impending risk of a material impact on economic activity and thus growth by the tragic events unfolding in Ukraine. The Monetary and fiscal aid to alleviate the economic distress from the pandemic are now in the process of being somewhat drawn to an end. 

The course of action sought to tame such elevated price pressures have led to notable moves in sovereign bonds, with prices declining and yields, which move inversely to prices, heading higher. The moves were noted across both the shorter- and longer-end of the yield curve. The shorter largely dictated by policy decisions while the longer-end determined by market sentiment.   

What is a yield curve? 

A yield curve shows the interest rates that buyers of sovereign debt demand to lend monies over various periods of time, it being overnight, for months, or years. Effectively, it shows the difference between interest rate on a shorter- and longer-dated bond. 

Because the economy is - under normal circumstances - expected to grow over time and experience inflation, which erodes the value of money, the rate of return differs across maturities. Typically, a higher fixed rate of return is earned at the longer-end, compensating for the longer duration. Shorter-term yields tend to represent what investors perceive central bank policy actions will be in the near term. That said, the yield curve should therefore slope upwards. 

Certain circumstances pointing to a clouded outlook tend to steer the curve to flatten which may become a recessionary signal, particularly if the curve becomes downward-sloping or inverted. 

A yield curve becomes inverted when yields at the longer-end of the curve, typically 10- and 30-year sovereign debt, fall towards those of shorter maturities, such as the three-month and two-year notes. In such scenario, bond investors are betting that there is less need for central banks to raise borrowing costs in the future. Instead they may need to encourage spending.

Recent moves along the US Treasury yield curve

To alleviate the economic despair brought about by the unprecedented coronavirus pandemic, central banks employed an accommodative policy stance. Tangible actions, such as interest rate cuts and controlling the yield curve through asset purchase programmes, proved crucial, encouraging spending while boosting economic activity. Corporates as borrowing costs remained low, tapped the primary market enabling them to survive.

Such actions drove yields at the longer-end to rise. Consequently, the yield curve steepened as bond investors started to expect higher yields in the future, due to a stronger economy, possibly prompting a faster pace of inflation should demand outpace the supply of goods. 

Such shape of the curve, has lately transformed to one that is inverted - the two-year yield rising above the 10-year - as investors started to worry that a faster pace of interest rate hikes by the Fed could cause a sharp economic slowdown. 

The Fed, in its March meeting in-line with market expectations, raised its target for the fed funds rate by a quarter-point to 0.25-0.5 per cent – the first increase in borrowing costs since 2018. Also, Fed Chair, Jay Powell signaled that it will take the necessary steps to tame inflation, even if that means increasing interest rates by more than 25bps at a meeting or meetings.

It is worth highlighting that while the inversion of 2 to 10-year yield curve may indeed point to a recession in the near term, market sentiment along with excessive supply – brought about by quantitative easing -may have possibly distorted the shape of such Treasury yield curve. That said, one should not completely exclude the yield curve’s predictive powers. Historically, an inversion of the yield curve preceded US recessions.

We believe that the Fed will ultimately continue to monitor economic data in the coming months, particularly the two key indicators which it rests upon; core inflation and employment, this to deduce whether a change in rhetoric, one deemed to be very hawkish, remains warranted. The Fed will certainly want to avoid a scenario where it must reverse its preceding course of action to, once more, instigate growth.

Disclaimer: This article was written by Christopher Cutajar, Credit Analyst at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

For more information visit https://cc.com.mt/. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.