The Power of the Yield Curve
What makes up a larger portion of the global investment market.... Stocks or bonds? If you were to survey 10 investors of average intelligence, there’s a realistic chance a majority of people would claim it’s the stock market. However, as alluded to at cmcmarkets.com, the global capitalization of the bond market going into 2020 was valued at approximately $100 trillion compared to a global market capitalization for stocks at about $70 trillion (CMC). With that being said, the bond market can certainly be a beneficial resource for stock investors as they allocate capital across different industries, sectors, and companies. So, what is the yield curve and how could it dictate the future state of the economy?
Yield is the fancy name for the rate of return of a bond and is generally calculated as the annual coupon payments divided by the bond’s par (face) value. When you purchase a bond, your yield will not change for the duration of the bond’s lifetime while the price of the bond may increase or decrease based on a number of factors which are outside the scope of this article. General economic knowledge tells us that as the length of time increases, the rate of return on an investment should increase due to greater risk. Where potential trouble may lie for a potential bear market is when the rate of return for short-term treasuries exceeds those of longer maturation. As indicated by gurufocus.com’s yield curve analysis, when the spread between the 10-year and 1-year yield dropped below zero, an economic recession followed the past 7 times (Gurufocus).
From a pure economic perspective while not taking into account lives lost over the past 2 years, Referring to the second image, did COVID-19 save us from a recession? If historical trends were to hold true, we should have or will be experiencing an economic contraction very soon. Alternatively, is higher inflation combined with potentially multiple rate hikes going to send us crashing like a house of cards? Or, as many investors wish, will the combination of fiscal and monetary policy by the Federal Reserve going to keep the economy afloat over the next couple of years?