Yield curve finds its rhythm again

• Compensating for uncertainty
• An unusual period of yield curve inversion
• Challenges in linking political actions to economic results

Most people spend their lives blissfully unaware of what a yield curve is and for the most part there’s little reason for the average person to care. However, we’ve recently come out of an unusual period for the bond market, and the yield curve in particular. Investors are taking notice and asking themselves what it means.

Compensating for uncertainty

When we speak of the yield on a bond, we mean the expected return on a particular bond if it’s bought today and held to maturity. When we speak of a yield curve, we mean a series of yields representing the yield on a bond with two years to maturity, with three years to maturity, with four years to maturity, etc. One should also note that the yields on such bonds are not typically subject to arbitrage. This means that an investor should expect to receive the same overall return after two years whether buying a single two-year bond today or two one-year bonds a year apart. If one option gave you a better deal, everyone would choose it and prices would adjust to remove the advantage. This keeps the market balanced, so there’s no “easy money” to be made by picking one option over the other. 

A “normal” yield curve typically has a positive slope, meaning longer-term yields are higher than short-term yields. (For instance, over the last 40 years, 10-year yields have been higher than 2-year yields about 85% of the time.) One way to interpret this, is that the market expects yields to increase over time. While this is part of the expectation, it really explains only a small fraction of the phenomenon. 

The bigger part of the explanation is uncertainty. Whatever my expectations may be of the future, I know circumstances can change over time, so I need to build this uncertainty into my forecast. The longer the time frame over which I forecast, the more room there is for circumstances to change. So, longer-term yields are typically higher than shorter-term yields to compensate for this uncertainty. 

An unusual period of yield curve inversion 

We’ve been in a period of an inverted yield curve. Unlike the typical case, yields on shorter-term bonds were higher than yields on longer-term bonds. This was driven by inflation coming out of the pandemic. At the time, central banks needed to raise rates to fight inflation which increased yields on short term bonds. Longer-term yields also rose but not by as much, as markets expected central banks to eventually win the inflation fight.

The U.S. Fed made its first bank rate cut in September. This followed cuts from Bank of Canada, Bank of England and European Central Bank. Commentary from these central banks was that an extended period of elevated bank rates had had the desired result of bringing inflation back to a long-term target of 2%.

Figure 1: Unusual yield curve inversion – 10-year yield less 2-year yield (Government of Canada)

Source: Bloomberg

Figure 1 shows the 10-year yield minus the 2-year yield. When it’s below 0% it means that the yield curve is inverted. Inverted yield curves are also often a sign of trouble ahead for the economy. As seen in figure 1, the recent yield curve inversion was unusual, in that it lasted an extended period of time (almost two years). The last time we saw an inversion of this length was in 1988 to 1990, well before many of today’s market participants began investing. 

Challenges in linking political actions to economic results

We’ve recently come through a pandemic the likes of which we haven’t seen since 1918. We’ve had two years of an inverted yield curve, something we haven’t seen since 1988. As of November 5, we have the results of a tumultuous U.S. election.

With Trump as the president-elect, along with a Republican Senate, and possibly a Republican Congress, we can expect to see some changes to U.S. fiscal policy. Even with the election concluded, it’s difficult to forecast how much of the policy laid out on the campaign trail will actually make its way to implementation. Further, it is a challenge to forecast how policy changes will affect the economy. How will tariffs affect inflation, how will immigration changes affect employment, and how will tax rates affect national debt?

We can confidently state that there will be many breathless new headlines over the next few years. Less clear is how policy changes will flow through to the economy, and to the bond market. With a dynamic economy, and with the various checks and balances in the political system in the U.S., we can look back in history and see that policy changes tend to have an evolutionary rather than revolutionary effect on the economy.

This means we should expect to see some month-on-month volatility in yields. In October, yields lifted sharply, possibly suggesting a renewed surge in inflation. But when we look over the year, the back and forth in yields washes out. October’s spike may be nothing more than a correction from overexuberance in September. 

As Mark Twain once said, while history may not repeat, it certainly rhymes. But we can dig into history. We review recent economic data points with a long-term lens. We can combine all this to make a reasonable forecast of where markets are going, and possibly we can also exploit the near-term volatility to capture some extra gains.

Source: Bloomberg

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