Inverted Yield Curve - Essay Example

Inverted Yield Curve Introduction A yield curve is a graph that shows interest rates on bonds or any other debt obligation of different maturities.The yield curve may be normal, flat, or inverted. A normal yield curve reflects higher interest rates for bonds with longer term maturity as compared to interest rates on bonds with shorter maturities. A flat yield curve indicates that there is little or hardly any difference between short and longer maturity bonds. The inverted yield curve, which is the subject matter of this essay, is a rare phenomenon, and indicates that bonds with longer term maturities command lower interest rates as compared bonds with shorter term maturities. This is because economy is not behaving normally and investors are loosing faith on long term investments, and it is a sign of recession being setiing into the economy. It is now believed that ‘Inverted yield curve’ is an indicator of pessimism being creeping into the behavior of economic set up of a nation. This belief and other important features of inverted yield curve have been examined in detail in this essay. Contents Introduction Features of inverted yield curve Operations of inverted yield Impacts of Inverted yield Conclusion References Features of inverted yield curve The value of a bond is dependent on its required return. “Whenever the required return on bonds differs from the bond’s coupon interest rate, the bond’s value will differ from its par value. The required return is likely to differ from coupon interest rate because either (1) economic conditions have changed; causing a shift in the basic cost of long term funds, or (2) the firm’s risk has changed. Increases in the basic cost of long term funds or in risk will raise the required return; decreases in the cost of funds or in risk will lower the required return” (Lawrence J. Gitman). This is the basic principle of interest rates and bond valuation. The above principle shows that the bond valuation is dependent mostly on economic conditions and the firm’s risk taking ability. So when reasons for lower interest on long term bonds as compared to short term bonds are analyzed, it reflects the character of economic conditions. In this way the bond interest rates works as barometer of the economic conditions. When we draw this scenario of lowering interest rates as compared coupon rates of bond of say $10 on a graph we get an inverted yield curve as shown below: Operations of inverted yield Normally long term investments are made in the avenues that show steady performances over a period of time and provide reasonable rate of return. It is seen that whenever stock market underperforms, investors withdraw money from stocks and usually invest in long term bonds. This raises the demand for bonds and as a result of demand and supply interactions, the requirement of funds through debts instruments decreases; and the result is decrease in the interest rates of bonds. Often it is seen that in order to control the situation the authorities intervenes and raises the interest rates for short term treasury bonds. From here the destructive role of inverted yield starts. Short term bonds provide greater yield than long term debt instruments; and if the this situation continue longer than expected the inverted yield starts its destruction work in ruining the economy to the extent of non- recoverability. Gloominess creeps in and the recession unwittingly falls into the economic mechanism. Impacts of Inverted yield A regular changing yield reflects the dynamic features of the economy, but when the yield is inverted for more than normal period, it is a cause of concern. “Whether or not the whole curve rises or falls relates to inflationary concern. The curve rises or falls within a limited range most of the time. But when the whole curve rises quickly and to the extreme, that’s a sign of inflation concern on the part of bond traders; when it falls quickly and to the extreme, there is an overriding deflation concern.” (Bill Cara, 2006). Accordingly inverted yield curve indicate both inflationary and deflationary trends and alert the authorities and investors to take necessary corrective steps. It is very difficult to predict economic slow down or recession. But predicting economic slowing down on presence of inverted yield curve has often been proved successful during the lasts few decades at least in the case of US. In other words presence of inverted yield curve has successfully indicated recession in the past and provided a sort of warning to those controlling the economic affairs of the nation. “In1996 Federal Reserve Bank economists Frederic S. Mishkin and Arteuro Estrella published a paper, which outlined that inverted yield curve, would predict a recession. Regarding this report, had shown every US recession post World War Two Era, and had preceded an inverted yield curve. Furthermore, subsequent papers written by these economists attributed the best economic indicator out of twenty six as an inverted yield curve that predicted recession four- six months in advance.” (Leonard Konis) Leonard Konis has further stated that “The longer an inverted curve remains or wider yield between short term and long term bonds is an ominous predictor for a future recession or low economic growth. Often, this reflects a down slope in the business cycle.” This may not be an economic theory, but is a proven indicator. If corrective actions are not taken and the interest rates for shorter term bonds continue to dominate the interest rates of longer term bonds, the impact of such imbalance would further shatter the economy to bring the economic doom closer and longer. Jonathan Wright has successfully tested the ability of inverted yield curve in prediction of recessions. He has created a relationship between yield differentials and predictability ability of the curve. Treating treasuring bonds as shorter period bonds he arrived at the predictability ability of the inverted yield curve as under: “If the fed funds rate is low, the probability of recession is also low unless the yield curve becomes inverted. However if fed funds rates is high there is significant (40%) probability of a recession when yield curve is flat, increasing to high probability when the yield curve is negative (70% at- 1.0%)……. Further a negative yield curve is a strong bear signal. Normally caused by the Federal Reserve raising short term interest rates to slow the economy, investors may contribute by driving long term yields down—switching out of equities into more secure investments.” (Incredible Charts) The inverted yield has worked every where in the world and predicted the recession in economies. In Asian countries where debt funds are not much in fashion as in the US and European countries, it is seen that the inverted yield has brought its effects through bank borrowings. “An inverted yield really ought to work as very good signal for economic trouble, because traditionally it tends to check growth in bank assets, and banks’ assets tend to be mirror image of the liabilities on corporate and household balance sheets. Slow the growth of one, and you slow the growth of the other, and thus slow the economy. The hinge of this, of course is the banks’ usual practice of borrowing short and lending long. When the price of short term liquidity is greater than can be recouped from lending long, the lending tend to stop. More generally, an inverted yield curve promotes holding cash/ near cash over buying/ creating financial assets. Does it work? Since 1975 there have been five major credit slowdowns, measured on a six month average month by moth momentum basis.” (Asia Sentinel). The situation is the similar in the Asian countries as in US where short term treasury bonds are used to control the yield, which has often been seen in past out maneuvered by the counter effects of inverted yield. In Asian countries, banks’ practice of borrowing short and lending short has shown the same tactics to control the recessionary effects because of inverted yield, but often seen as failures because of the negative impacts of inverted yields. Therefore, it can be said that the signs of recessions are available as soon as inverted yield crops into the economy; but it is a different matter whether actual recession gets avoided by concrete economic measures taken by the authorities. Conclusion Inverted yield sets in when long term bonds start yielding lower than short term bonds. Though this is a rare phenomenon but it sets the alarm bells ringing into the normal economic workings. In past these occurrences of negative yields often resulted when control measures taken by raising interest rates of treasury bonds (short term) or short term borrowings of the banks did not worked as planned by the authorities to control the temporary upsets in the yield of long term debt instruments. But once inverted yield curve sets into an economic system, its operations leads to indications that economic future is recessionary. These indications of recession of the inverted yield curve have often come true in most of situations in the past, and should be taken seriously by authorities. References Asia Sentinel, Understanding the yield curve, viewed on April 30, 2008, http://www.asiasentinel.com/index.php?option=com_content&task=view&id=1033&Itemid=32 Bill Cara, Inverted Yield Curve: Understanding Its Implications, October 24 2006, http://seekingalpha.com/article/19095-inverted-yield-curve-understanding-its-implications Incredible Charts, Yield curves, viewed on April 30, 2008, http://www.incrediblecharts.com/economy/yield_curve.php Lawrence J. Gitman, Principles of Managerial Finance, Eleventh edition 2006, Interest Rates and Bond Valuation, Chapter3, page 301. Leonard Konis, Inverted Yield curve: One step away from recession, viewed on April 30, 2008, http://www.helium.com/items/102483-predicting-recession-economic-united Read More