Y is for Yield Curve

The Yield Curve is a simple idea with surprising predictive power. The Yield Curve is a magic eight ball, which tells the interpreter what they want to hear. The Curve is a bunch of numbers. The Curve tells you everything that happened, but only in retrospect.

All of the above.

Basic yield curve shapes, colotrust.com.

People really wax poetic about the yield curve. There’s one guy at NPR that goes ga-ga over the yield curve and has done podcasts on it with clock-like regularity:

GARCIA: …I got to say, it is one of my favorite indicators.
SMITH: Cardiff, you love the yield curve.
GARCIA: Very much.
SMITH: Every time we talk about the yield curve, you kind of light up. And I have no idea why this is the case.

NPR podcast, Apr 6, 2021.

Just Graph Some Interest Rates

The yield curve is a graph of interest rates, specifically what the government would pay you for investing in Treasury-backed securities. Yield just means how much money in interest you’d get back for buying a T-bill.

You can invest for different periods of time, from three months to 20 years. I don’t know who would want to tie up their money for 20 years. But, as sure as shootin’, if I were going to give somebody my money for 20 years, I’d want them to pay me a LOT higher interest. Thus, interest that the government would pay you for long term investments would be higher than what it offers in the short term because you need an incentive to tie your money up.

If you graph those interest rates with the time period along the bottom axis, you can see how it might increase over time, like in the line for 1985 or 2003 below.

Once Upon a Time, When Ogres Roamed the Earth, There Were Interest Rates of 20%

One curious historical note about that graph is visible on the vertical axis. See how it goes all the way up to 16? In those old corset and buggy whip days of the early 1980s, we had ridiculously high interest rates. The rates were high because the government’s monetary policy was trying to “tame inflation.” Inflation had spiked in part because the middle East decided that the oil they had been freely giving to their previous colonizers was something they should restrict. Gas lines. Embassy hostages. Etc.

Previous historical curves, graph from frsbsf.org.

Inflation was also high because the government (via the Federal Bank) had previously been increasing the money supply to pay for the Vietnam war, finance rising labor costs, and promote perpetual posterity for political reasons. Nixon wanted money cheap; Carter inherited 8% inflation. Under Carter, the Fed pushed interest rates up. When I was in college, I stuck my meager savings in some mutual funds which actually earned 10%. I thought it was a good deal and was forever annoyed afterward that no one would pay me so much for doing nothing. That’s called perspective.

For reasons that can’t be shoved into < 820 words, the economy got wild and free in the late 2000s, which led to a mortgage-backed securities crash that tanked the entire country. In order to help companies who then wanted to borrow money, the government set interest rates super low. That’s when savings accounts went from earning 2% to earning I-can’t-find-it-without-a-magnifying-glass 0.02%. If you were born in 1990, you would have a different perspective about “normal” interest rates.

Beside knowing now that a normal yield curve rises because future interest rates ought to be higher than current interest rates, you should also see that all sorts of nonsense causes interest rates to go up and down. Whether Britain owned the Suez Canal in the 1880s, why Nixon had a hard time getting voters to like him, how much Fed chair Paul Volcker disliked President G.W. Bush and tried to hamper his re-election, and so on. Things you can’t stick on a graph.

The Yield Curve Becomes a Crystal Ball

An interesting facet of the yield curve, which is why the dude on NPR likes it so much, is that it seems to be predictive of recessions. Sometimes the T-bill rates for long-term securities earn lower rates than short-term. The yield curve becomes inverted, curved downward instead of upward. How could this even be?

Though the government sets T-bill rates, it’s based on what the market will pay. When the curve inverts, it’s because investors believe that future interest rates are going to drop. Why? Suppose the economy has been expanding rapidly, whether due to de-regulation, cheap oil, monetary policies, dot com booms, who knows? Something happens that suggests storm clouds on the horizon. The R-word: Recession.

Graphic from seekingalpha.com.

Investors believe that interest rates “now” are too high and that the economy is overheated. The yield curve inverts, and when it’s done that in the last 30 years–in the graph, when the blue line dips below the black line, a recession happens within a year. Notice that what the stock market does–the red line–is NOT a good predictor of recessions. Ignore the price of stocks if you want to predict whether the job market will get better or worse.

Yes, But What Have You Done For Me Lately?

The most recent data on yield curves is super interesting. There was a bit of an inversion in the graph for April 2019, which hinted at something of recession for 2020 (and this is the point) before the pandemic even hit.

Notice also how the vertical axis stops at 3.5%. No more 16% interest rates, at least for now.

Current=April 2021, graphic from Guru Focus.com.

In April 2020, which was right after the COVID lockdown, the curve was rising. The Fed had slashed interest rates to make loans easier for struggling businesses. In April 2021, as the economy is about to reopen in full, the curve is very steep. We’re coming out of a recession (almost an “economic shudder”) and entering what should be economic expansion.

Man! If only this curve could have told us in April 2019 to stock up on toilet paper and N95 masks, then it would be really predictive!


We’re nearing the end of our A-Z look at Accounting. One more day left!

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