How the Inverted Yield Curve Affects Lending and Borrowing Transactions

[TL; DR]

A yield curve compares the interest rate of long term debt instruments to that of short term ones.

A normal yield curve shows a positive relationship between the interest rate and maturity time of debt instruments.

An inverted yield curve shows a negative relationship between interest rate and the maturity time of debt instruments.

In most cases, inverted yield curves indicate impending economic recessions.

Introduction

Investors, governments and consumers rely on financial indicators and trends to predict the future performance of an economy. These economic stakeholders make their decisions based on anticipated economic developments in the country. Some national financial metrics are derived from the entire economy while others focus on key economic aspects such as borrowing and lending. Today, we focus on the inverted curve which gives several economic indications.

What is a yield curve?

In general, a yield curve is a graph that shows the interest rate for short term and long term debt instruments. The interest rate is on the vertical axis of the graph while the maturity time is on the horizontal axis. In a normal case, the interest rate and the maturity time of an asset have a positive relationship. This means that if the interest rate rises the time to maturity increases and vice versa. The following diagram shows a normal yield curve.

Source: Derivativelogic

The graph shows a scenario where the borrowers pay higher interest for long term securities such as bonds. This is because the longer the period the higher the risks involved.

It is more difficult to predict the long run economic conditions of a country, say 10 years, than to anticipate its economic performance within a short period such as 6 months.

What is an inverted yield curve?

An inverted curve is a graph that shows a negative relationship between the interest rate and the time of maturity of a debt instrument. This means that the yield of a debt instrument such as bond is higher for a shorter period than a longer one. Used here, yield means the cost of borrowing funds or interest rate.

Source: Forbes

Flat Yield Curve

The third type of yield curve is the flat yield curve. This type of yield curve occurs when the debt market is within a transition, when the yield of the long term and short term maturity debt instruments are the same. In such a situation the market does not encourage or discourage lending and borrowing. This normally occurs when there is uncertainty pertaining to the direction the debt market is taking.

Source: Forbes

As you see, the yield is the same despite the maturity age of the debt instrument. By the way, debt instruments such as bonds have varying maturity times. For example, there are 2 year, 10 year and 30 year debt instruments. What differentiate them are their yields.

Investment instruments

As we explained above, there are short term and long term maturity debt instruments. Bonds are a common type of debt instrument we find in the market. There are corporate and treasury bonds. Treasury bonds are government securities with fixed interest rates and maturity ages of between 10 and 30 years.

The yield of both short term and long term maturity securities depends on their supply and demand in the market. If there is a large difference between the yield of short term and long term maturity securities the yield curve is steep. In this case, the yield is very high for the long term debt instruments.

Source: Crossingwalletstreet

Why much news when there is an inverted yield curve?

When a country, such as the United States, has an inverted yield curve there is so much “noise” in the economy. This is because an inverted yield curve creates panic among lenders and borrowers.

Many analysts believe that an inverted yield curve predicts a recession in the economy. The reason is that during such periods, investors prefer long term investments against short term ones due to the fear that the economy may perform badly in the future. Essentially, they base such predictions on the existing macroeconomic environment in an economy.

In the past, the inverted yield curve predicted recessions several times. According to economic observers, most of the recessions that occured in the United States since the 1950s were preceded by inverted yield curves. For example, the last inversion started in 2005 and ended in the great recession that occured in 2007 and was followed by the 2008 global financial crisis.

Using the inverted yield curve to make investment decisions

As noted, the inverted yield curve gives a clue on the direction the economy may go. First, it helps you to predict future interest rates. If you are a borrower then you need to time your borrowing with debt instruments that have low interest rates.

As an investor, the curve helps you to detect securities that have higher yields at a certain period. For example, you have to avoid securities that are overpriced and are likely to bring little profit or even losses.

What this implies, also, is that short term investment instruments yield more than long term ones. As an investor, you should go for short term securities. And, this is where investing in cryptocurrencies makes more sense. There are many investment opportunities in the crypto sector where you can put your funds in short term assets.

For instance, if you time your entry and exits in crypto trading you can earn more than most long term traditional investment instruments.

If a business wants to borrow it should go for long term securities since they have more favourable rates than short term ones during that phase.

How Inverted Yield Curve affect Lending transactions

In general terms, yield curves influence the willingness and ability of individuals and businesses to get funds through the traditional financial sector. They also affect the amount of funds the lenders avail to the financial market.

The inverted yield curve implies that traditional lending financial institutions such as commercial banks borrow short term funds at higher interest and offer long term loans at relatively lower interest. This means that the lending institutions get very low return, something they cannot afford to do for a long time and at large scale.

As a result, most financial institutions stop lending during the period when there are inverted yield curves. Ultimately, this negatively affects the economy due to few credit facilities. In industries, productivity decreases as businesses cannot access funds to support their operational and growth activities. The following graph shows the possible effects of lack of credit lines in an economy.

Source: Croakingcassandra

In this instance, productivity decreased during the global financial crisis that started in 2008.

Nevertheless, when there is a normal yield curve the lending institutions borrow short term funds with lower interest rates and give long term loans or other credit facilities. Since there would be a higher spread between the two, they make profit. Remarkably, profit is the only incentive for lending institutions to offer credit facilities.

Conclusion

To summarize, an inverted yield curve occurs when the interest rate of short term debt instruments is higher than that of long term ones. This situation discourages lending since the lenders do not earn high returns. In the past, inverted yield curves were precursors to economic recessions such as the 2008 global financial crisis. However, borrowers should take cue on how to access the best credit facilities.

Author: Mashell C., Gate.io Researcher

This article represents only the views of the researcher and does not constitute any investment suggestions.

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