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Yielding Up the Answers

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You've heard people talk about the yield curve. You even picked up enough of the discussion on CNBC to throw around the term at the last office water-cooler discussion, intoning your prognosis on whether the inversion predicted a recession. Despite your somber but brief discussion, however, you're secretly glad that no one asked you to explain what a yield curve was and what the terms "flattening yield curve" and "inversion of the yield curve" mean. You don't have a clue.

Neither do a lot of people, but it's a simpler concept than many imagine. First, for the benefit of newbies, what's a yield? The word can have several definitions, but for the purposes of studying the yield curve, it's the effective rate of interest paid on a treasury bond. Generally, when bonds go up in value, yields go down, and vice versa. When bonds are lower in value, higher yields are needed to entice buyers away from equities.

The bonds used to study the yield curve are government bonds. These bonds can be short-term treasury bills maturing in 12, 26 or 52 weeks; treasury notes maturing in 2,5 and 10 years, and treasury bonds maturing in 20 and 30 years. The three types of government bonds--T-bills, treasury notes and treasury bonds--are collectively known as "treasuries."

Normally, longer-term treasuries would yield a higher interest rate than shorter-term ones. That's to tempt investors to tie up their money for longer periods. Investors want more compensation if they're going to risk their money for a longer period of time.

To study the yield curve, yields are plotted on a chart. The vertical axis is the yield's amount and the horizontal axis is the maturity of the treasuries. Starting at the far left, where the two axes meet, the shorter-term T-Bills are plotted. Next come the treasury notes and then the treasury bonds on the far right.

When yields show a normal pattern, the yield curve arcs upward as it extends from left to right on the chart. This reflects the fact that yields increase as maturities do. The following chart illustrates a normal yield curve, although I'd argue that this illustration from Investopedia shows a flattening itself to the far right of the chart.

Normal Yield Curve:

A flattening yield curve occurs when the rates for shorter-term and longer-term treasures are equal or nearly equal. The line is horizontal. An inverted yield curve occurs when yields for shorter-term treasuries are higher than those for longer-term ones. This type of curve proves rare, but such an inversion occurred December 27 when the yield for the two-year treasury note moved higher than that for the ten-year. A simplistic and exaggerated representation of an inverted yield curve would look something like the chart below.

Inverted Yield Curve:

Some economists have noted that inverted yield curves sometimes predict economic slowdowns or recessions, with such an inversion showing that money is tight after a period of Fed tightening has driven short-term rates higher. With most inversions, yields or rates for short-term treasuries and longer-term treasuries are high with yields for a shorter-term treasury rising above those for a longer-term one. This week, many economists sound the "this time it's different" bell. That's a bell tone that chills investors who have heard that statement addressed to early 2000's high prices on stocks with no earnings and to low VIX levels just before rollovers.

A difference does exist, however: this time, the ten-year's yield remains low and an impending December 29 auction of two-year notes pressured prices for those treasuries, sending the two-year's yield higher.

One economist argues with the use of the two-year note to measure inversion, claiming that the 10-year's yield should be measured against that of the fed funds rate and not that of the two-year note. That discussion, however, remains beyond the scope of either my understanding of economics or the appropriate length for this primer on the yield curve.

One dramatic example of an inverted yield curve occurred in March 2000, as illustrated by the Dynamic Yield Curve chart available on StockCharts.com.

Dynamic Yield Curve:

Copyright, Stockcharts.com

This yield curve chart was benchmarked on March 10, 2000, just prior to the last swing high before the SPX toppled over and began falling into its 2002 low. As Jim Brown noted in his Wrap December 27 of this week, a severely flattened or inverted yield curve forecast every recession and many economic slowdowns since 1954.

Certainly, such memories worry some economists and have focused attention on the December 27 inversion, although others dismiss the belief that such an inversion predicts a recession now. Those nay-saying economists point to recent strong economic data and the impact that foreign buying of U.S. treasures might have on the curve. It's true, too, that while such inversions of the yield curve always precede recent severe slowdowns or recessions, not all such inversions are followed by severe slowdowns or recessions. In his December 27 Wrap, Jim Brown also reported the sometimes-heard Wall Street adage that "an inverted yield curve has correctly predicted ten of the last five recessions."

Although this article provides only an overview of the term "yield curve," and not an exhaustive discussion of the various reasons why this one might or might not be predicting a recession, you're primed to discuss it with more assurance at the next office water-cooler discussion. You're also primed to take protective measures just in case this time it's not different after all.

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