The yield curve is a vital data set that doesn’t get enough attention except from dense economic conferences or papers. But understanding how it works helps us understand what the bond market is thinking about interest rates, inflation and economic risks.
The yield curve is very simple. It’s the difference (spread) between between two bonds with different durations but issued from the same government. Because it is the same issuer, the risk is largely the same and typically the yield curve is upward sloping — this means longer-duration bonds have a higher yield than shorter-duration ones.
The higher longer-dated duration yield is mostly because of inflation risk. If you’re earning a 4% yield over the next decade that is fine right now if inflation is 2% as you have a fair real return. But what if inflation spikes to 4%? Now your real return is zero — not great.
Developed economies had about 40 years of low inflation before the pandemic inflation spike — so inflation expectations had been very low. However, the US yield curve was still surprisingly volatile.
This is the point about what the market is expecting. If the yield curve is moving higher, the bond market is expecting higher inflation. They may be wrong, but they are putting their money where their thinking is.
And importantly in the decade between the financial crisis of 2008/2009 and the pandemic, yield curves for developed markets had been decreasing as inflation targeting worked not only on inflation but also on inflation expectations.
An inverted yield curve is when shorter-duration bonds have a higher yield than longer-duration ones. This indicates serious bond market concerns about the immediate future, typically indicating a looming recession.
In the US, nearly every recession since the 1940s has been preceded by an inverted yield curve. This doesn’t mean that an inverted yield curve always means there will be a recession. Often there isn’t one, but it does show what market participants are worried about. If you’re worried about a recession in the short term you want to be paid more to hold the debt. When you’re looking at a decade or more in the future, the recession happening this year or next is not really a worry.
Right now the US yield curve is steepening, both bonds are falling but the shorter-duration ones are falling faster. This tells us the market expects interest rate cuts while the longer-term bonds are more concerned about inflation eroding their returns. That’s why they’re demanding more yield for that risk.
This is why UK 30-year yields are at their highest levels this century and Japanese 30-year yields are at their highest levels ever.
Low rates now are great, but the market is not convinced that inflation has been tamed. Lower rates could push inflation even higher, meaning an even steeper yield curve ahead.
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