Reading the signs (and curves)

If you want to make sense of financial headlines and figure out how developments relate to you and your business, you might want to upgrade your understanding of bond markets and fixed income a little. Because, as Martin Oehmke, Professor of Finance at LSE, explains, forearmed is forewarned.

In March 2019, the US Treasury yield curve inverted and sent the financial world into a squall of analysis and speculation. And understandably so.

Put simply, the treasury yield curve shows the yields – or returns earned– on short-term and long-term bonds issued by the US government. It’s a way of measuring how bond investors feel about the economy – whether they expect the economy to get better or worse in the years ahead. When the yield curve inverts, it means that longer-term interest rates have fallen below short-term interest rates, a sign that investors expect the economic outlook to worsen. And that a recession could well be on the horizon.

Historically, inverted yield curves have been fairly reliable harbingers of economic woes. Since December 1969, there have been six major recessions in the US, each of them foreshadowed by longer-term rates falling below shorter term rates.

But how dependable are the curve’s predictive powers in reality?

While some market watchers believe that the outlook for the coming decade has worsened substantively, others argue that the structure of the economy and the role of central banks have changed – particularly in the post financial crisis era with the Fed and others enacting unconventional monetary policies – and that this has had the effect of skewing the curve and distorting its predictive capabilities. It could be that the negative signals about the US (and hence, the global economy) are not as reliable as we think, and that the economy will continue to grow in spite of what the yield curve is telling us now

So who’s right? who’s wrong? and what does it all mean for you and your business?

No one can tell you with 100% certainty what’s in store for the global economy. However, building a good understanding of fixed income markets will ensure you become familiar with the kinds of cues and economic signals you need to be on the watch for in order to plan accordingly and brace for change ahead of the market.

It’s important in this context to understand the economic concepts and mathematic principles that underpin bond markets. This isn’t as challenging as it sounds. A good place to start is to dig a little deeper into how yields are determined and what they reflect. For example, one reason why long-term yields can be low is that investors expect low future interest rates. Another is that investors demand a relatively small premium to bear future interest risk. And, nowadays more than ever, it is important to understand how major players like central banks influence fixed income markets through their policies.

You don’t need to a be a PhD in economics to make sense of it all. But you do need an understanding of how modern fixed income markets work. Educating yourself and acquiring a few good tools and frameworks to gain clarity is a great strategy. After all, fore-armed is forewarned.