L10 1 Yield Curve
Understanding the Yield Curve
The yield curve has gained attention due to its unusual shape, leading to concerns about a potential recession.
Basics of the Yield Curve
Present Value and Interest Rates:
Present value decreases as interest rates increase.
Formula: Future Value W paid T years from now is valued at W / (1 + r)^T, showing the inverse relationship between interest rates and present value.
Bond Valuation:
Bonds pay a series of future cash flows, not just a single payment.
Inverse relationship: As interest rates rise, bond values decrease; conversely, if rates drop, bond values increase.
The Fisher Equation
Fisher Equation:
Nominal interest rate (I) = Real interest rate (R) + Inflation rate (π).
Different interest rates apply to cash flows due in different years, emphasizing the term structure of interest rates.
Term Structure of Interest Rates
Typically, longer maturities offer higher interest rates, reflecting the risk of locking up money for a longer duration.
Example: Banks typically provide better rates for longer term CDs (Certificates of Deposit).
Normal vs. Inverted Yield Curves
Normally, the yield curve slopes upward, indicating higher interest rates for longer maturities.
Comparison of Yield Curves:
Right Graph: Normal upward slope (Sept 2017).
Left Graph: Inverted curve where short-term rates exceed long-term rates (Sept 2024) raises concerns about a potential recession.
Historical Context
Previous inversions often preceded economic recessions:
2019 Inversion: Preceded the 2020 recession, although unrelated to COVID-19.
Graph Analysis: Indicates that yield curve inversions correlate with previous recessions since the late 1970s; each inversion triggered recessionary periods.
Current Trends in the Yield Curve
Recent data shows the yield curve slightly flattening after inversion, hinting at a potential return to a more normal state.
The graph tracking the 10-year rate minus the 2-year rate indicates recent shifts back to positive values, feeding speculation about the economy's stability.
Implications of an Inverted Yield Curve
An inverted yield curve suggests market expectations of declining long-term interest rates and possible economic recession.
Market reactions to Federal Reserve interest rate changes influence expectations.
The inverted yield curve acts as a signal rather than a cause of recession; it reflects the beliefs of informed investors regarding economic conditions.
Conclusion
Although historically a reliable predictor of recessions, the inverted yield curve is not infallible; it signals increased market concern about economic sustainability.
L10 1 Yield Curve
Understanding the Yield Curve
The yield curve has gained attention due to its unusual shape, leading to concerns about a potential recession.
Basics of the Yield Curve
Present Value and Interest Rates:
Present value decreases as interest rates increase.
Formula: Future Value W paid T years from now is valued at W / (1 + r)^T, showing the inverse relationship between interest rates and present value.
Bond Valuation:
Bonds pay a series of future cash flows, not just a single payment.
Inverse relationship: As interest rates rise, bond values decrease; conversely, if rates drop, bond values increase.
The Fisher Equation
Fisher Equation:
Nominal interest rate (I) = Real interest rate (R) + Inflation rate (π).
Different interest rates apply to cash flows due in different years, emphasizing the term structure of interest rates.
Term Structure of Interest Rates
Typically, longer maturities offer higher interest rates, reflecting the risk of locking up money for a longer duration.
Example: Banks typically provide better rates for longer term CDs (Certificates of Deposit).
Normal vs. Inverted Yield Curves
Normally, the yield curve slopes upward, indicating higher interest rates for longer maturities.
Comparison of Yield Curves:
Right Graph: Normal upward slope (Sept 2017).
Left Graph: Inverted curve where short-term rates exceed long-term rates (Sept 2024) raises concerns about a potential recession.
Historical Context
Previous inversions often preceded economic recessions:
2019 Inversion: Preceded the 2020 recession, although unrelated to COVID-19.
Graph Analysis: Indicates that yield curve inversions correlate with previous recessions since the late 1970s; each inversion triggered recessionary periods.
Current Trends in the Yield Curve
Recent data shows the yield curve slightly flattening after inversion, hinting at a potential return to a more normal state.
The graph tracking the 10-year rate minus the 2-year rate indicates recent shifts back to positive values, feeding speculation about the economy's stability.
Implications of an Inverted Yield Curve
An inverted yield curve suggests market expectations of declining long-term interest rates and possible economic recession.
Market reactions to Federal Reserve interest rate changes influence expectations.
The inverted yield curve acts as a signal rather than a cause of recession; it reflects the beliefs of informed investors regarding economic conditions.
Conclusion
Although historically a reliable predictor of recessions, the inverted yield curve is not infallible; it signals increased market concern about economic sustainability.
