The financial media has fallen all over itself of late to brow beat its watchers into believing that the current shape of yield curves point to a looming economic recession. While fun to watch, they fail to address the WIIFM (What’s In It For Me) factor for borrowers, and a needed explanation is due. In the following paragraphs, we cut out the noise and explain how yield curves can work for you as a borrower.
Yield Curve Inversion – What is it?
Yield = profit for an investment. Curve = arc. Inversion = transposed. Yield curve inversion means the trajectory of investment returns well into the future has been turned upside down. Applied to the U.S. Treasury bond market, the ‘risk free’ baseline for every global asset class, understanding the concept is critical. And if you do have an appreciation (or fear) of interest rates, you’ve heard of the phenomenon, perhaps ad-nauseam, that “yield curve inversion means a recession is coming.”
Now, if you’ve been a long-time reader of our publications, perhaps you also know that “inversion of the yield curve has predicted 10 of the last seven recessions.” or “an inverted yield curve precedes recessions with a 12- to 18-month lag.”
But really, what is an inverted yield curve and what makes it worthy of your attention? Put simply, an inverted yield curve is when interest rates (yields), which determine the cost of borrowing money, are higher for short term debt than for long term debt. Traditionally, and empirically, it makes sense that you’ll pay a higher rate of interest the longer you need to borrow. The difference in interest rates for a short-term versus a long-term loan is what causes lenders to part with their dollars for longer periods of time. As an investor, a 2-year CD should pay me 3% a year and a 5-year CD should pay me 5%, and a 10-year Treasury note should pay me 7%. This same relationship also holds true for your mortgages and auto loans and other consumer borrowings of different terms. But for Treasury debt, a trillion dollar market where default risk is presumed to be zero, yields exist in a purer form, and can tell us different things about the underlying economy, capital markets, global trade, and investor sentiment.
But first, a quick review:
Short Term Rates < Long Term Rates = a “normal”, upward-sloping yield curve, that looks like this:
Short Term Rates > Long Term Rates = an “inverted” yield curve, that looks like this:
Quick Study: The Mechanics of the Treasury Yield Curve
Let’s dive into the numbers and get a sense for the mechanics of the current Treasury yield curve inversion, and then look at the shape of the curve after that. Here are the primary components of the Treasury yield curve today (4/24/19) in table and curve form:
Yield Curve “inversion” or “steepness” or “flatness” is measured by looking at different Treasury bond maturities and gauging them against each other. An example of this is looking at the yield difference between the 2yr and 10 year Treasury yields, then graphing these yield differences over time. To get the big picture, this is process is done not only for the 2-year/10-year Treasury curve, but also for the 2yr/30year, 3yr/10yr and the 2yr/5yr Treasury curves. Once all these are plotted on a graph, it looks like this:
Knowing that Treasury yields change every day throughout the day, a yield curve’s shape also changes throughout the day and from day to day. The true curve inversion that exists today is the 2-yr yield to the 5-yr yield curve (the black line in the graph above). The true inversion that most market economists see as a recessionary ‘trigger’ is when the 2-year yield exceeds the 10-year, a relationship which is still upward sloping by 21 bps (0.21%) today. Perhaps the inversion won’t happen this time – maybe the Federal Reserve and the resilient economy can steer our yield ship back on course.
What Curve Inversions Tell Us
What are the overarching implications of the inversion, which will magnify if the curve inverts more? The return for short investments exceeds what you get for longer term investments, and thus sitting on short-term cash is better than making long term plans for growth, like building a factory or expanding a workforce. Why sacrifice time when it pays less? The logic is simple and sound, but the impact of this mindset can start a dangerous downward spiral, as lack of investment begets stagnation and decay for businesses. But as with any potential pitfall, perhaps we can identify opportunities in this market. By the way, for a deep dive on yield curves, see our previous publication, “Understanding the Yield Curve: What You’ve Always Wanted to Know but Were Afraid to Ask” (link).
What Curve Inversions Really Mean for Borrowers
For our clients, particularly larger borrowers with commercial real estate assets and loans based on floating rates like LIBOR, we talk about interest rate caps and swaps all the time to manage the risk of LIBOR rising. In an upward sloping, “normal” yield curve environment, the market is telling us that LIBOR should rise in the future, which is a scenario we respect primarily because of the fear of paying more interest. In the current environment, the market expects LIBOR to fall in the medium term.
What’s in it for you? Interest rate swaps are available at rates near or below what LIBOR is today – you can participate in the flatness of the yield curve by getting a fixed rate well into the future that is lower than where you are floating today – great! However, be careful. If a recession is truly around the corner – as the current yield curves imply – today’s low rate can look awfully high in the future. The problem gets worse if your business starts to feel the recession and your interest payments begin accounting for a larger percentage of cash flow. Alternatively, if you borrowed at a floating interest rate today and hedged the floating rate risk with an interest rate swap, an interest rate swap held as rate expectations fall can go significantly negative in value, and while the cash impact will be on monthly basis, if you were looking to refinance or sell an asset, the swap liability can kill the economics of your deal.
Regardless of your view of where the economy and interest rates are headed, there’s an undeniable bright spot in the yield curves that exist today: they’re not really inverted, but rather “flat”, and that’s a big opportunity for borrowers. What this means for borrowers is that interest rate hedges that have an option component, e.g. rate caps, corridors, or swaptions, have become remarkably inexpensive of late.
To illustrate this point, recall that an interest rate cap is merely an insurance policy on a specific number of LIBOR resets at a specific threshold. So a 5-year, 4% LIBOR rate cap gives the purchaser 20 quarters of LIBOR insurance if the index resets above 4%.
The chart below shows historical LIBOR (yellow), the 5-year swap rate (white), and the cost of a 3-year LIBOR cap struck at 4% (blue) over the last ten years. LIBOR and the swap rate are percentages, both now near 2.50%, and the cap cost is denoted in basis points (0.16% means a $10MM cap would cost 0.16% X $10MM =$16,000):
Source: Bloomberg Professional
You can see the diversion in the last five years. As LIBOR began to rise (again, the yellow line), the swap rate began to rise in tandem, but the cost of a cap on LIBOR has languished, and even plummeted further in the last six months. The chart for a 3% LIBOR cap is similar, costing about $65,000 today, thus most rate caps, regardless of their protection level, are relatively cheap.
But minimizing price isn’t the most important take away from buying an interest rate cap in a flat or inverting yield curve environment. The real power of a rate cap is the flexibility it provides. Rate caps allow you to minimize your opportunity cost if interest rates don’t rise. Sure, you’ve written a check upfront to buy the cap, you’ve paid for the “insurance”, and the metaphorical house has not burned down, but your overall interest expense has been unimpeded to float lower, which may be the most likely scenario in a recessionary environment. This exact scenario played out in 2007-2009, when the yield curve flattened as the Fed attempted to cool an overheating housing market, and many commercial borrowers had the chance to lock in their floaters at or below LIBOR. Two years later, those deals were so far underwater that many borrowers defaulted or were hampered for years by larger interest payments, even as the floating rates trended to zero and their businesses floundered. The out-year pain would have gladly been traded by those borrowers in hindsight for a nominal upfront payment for a rate cap.
The Bottom Line
The current flat or slightly inverted yield curves are telling us that: 1) floating interest rates may fall or stay very low in the future 2) financial markets offer products to insure against rate spikes, yet allow you to float if they don’t spike, and 3) those products are very cheap right now. The smart money is strongly considering borrowing floating and hedging the risk with a simple rate cap. Curious? Call us at 415-510-2100 or today.
Current Select Interest Rates