The yield curve inversion is a forecasting tool which many had professed as reliable
graphic by MZUKRI
YIELD curve inversion has become a common financial term in news reports these days and it has been rattling global markets.
Shocks happen when yields on the short end of the yield curve are higher than the longer end and said to foretell the coming of a recession or weaker economic activities.
For the ordinary man on the street, it is another foreign term used in the financial markets which is meant to confuse people.
So, what is the big fuss about the inversion? At the heart of it, the yield curve inversion is a forecasting tool which many had professed as reliable.
It is easier to predict rain in Taiping, though, than the market.
In the financial world where information is money made or saved, using such forecasting techniques offers a competitive edge to businesses.
Participants of global financial markets do forecasting almost on a daily basis. This is reflected in the pricing of financial assets on the exchanges.
Forecasting using structural models — which are based on structural hypotheses and complex mathematical equations — use data such as inflation, trade, lending or employment figures that are made available on a monthly or quarterly basis, and have been found to be unreliable of forecasting inflection or turning points of an economy.
Thus, indicator models that use financial variables such as yield rates, stock price indexes and monetary aggregates to predict real economic activity have become popular as these figures are available on a daily basis.
The idea of the forecasting using data like bond yields is derived from modern asset pricing theories that advocate a relationship between expected asset returns and investors’ expected consumption plans.
The theories generally say that investors would benefit more from one dollar in a recession when consumption levels are low, than from one dollar in the peak of a business cycle when consumption is high.
This causes investors to invest into assets that will provide a hedge against an unexpected downturn in the economy. If a recession is expected next year, investors will move into a one-year bond at the expense of the present consumption.
The action of trading the present consumption for future consumption is known as a marginal rate of substitution.
The rate of substitution is determined by expectations of the economy or business cycle, and is reflected in asset prices.
The demand for bonds will lead to a rise in the price of the asset class and a drop in the yield rates.
The interest rates or yields of defaultfree securities with different maturity periods, when plotted on a graph, form a yield curve.
The difference between two defaultfree securities with different maturity periods is the yield spread. A positive yield spread is associated with real economic expansion and a flat or inverted yield curve with decline. The explanation for this lies in two possible hypothesis.
The policy anticipation hypothesis says the yield spread may reflect the country’s monetary policy stance. If the monetary policy is tightened by the central bank, the short-term interest rates rise, but at a much higher rate then the long-term interest rates.
The yield spread will narrow and cause the output in the economy to fall after a lag period. Vice versa, if there’s a cut in the short-term interest rates, the yield spread would increase and encourage investment that leads to economic growth.
The alternative hypothesis states the yield spread and output reflect the expectations of the financial market participants towards future economic activity.
If a recession is anticipated in the near future, as is the case now, shortterm and long-term interest rates are expected to fall to induce economic recovery.
During this period, the yield curve would be downward sloping. The opposite will hold true if the economy is expected to grow in the future.
Companies expecting good business prospects would be tempted to increase investment through long-term borrowing. They would issue longterm bonds, which would lead to an increase in the supply of such securities.
The prices of bonds would then fall, while yields rise, resulting in a steeper yield curve which is associated with future increase in real economic activity.
While the Malaysian economy is expected to continue to grow by about 4.5% this year, our trade dependent economy could lose steam when end-consumer economies like the US, Europe and China start to slow.
And as stock values and investment returns start dropping across the world, the wealth effect comes into play as lower consumption slows growth, which partly explains why the yield curve is big news these days.
All these to predict the next economic fallout.
Bhupinder Singh is the corporate desk editor of The Malaysian Reserve.