Visualizing Yield Inversion
Updated
When investors have a poor outlook for the economy, what do they do? They buy the longest term debt they can because it's one of the ways to price in the uncertainty of "right now" into the long term. Therefore, rational actors would do something like this:
Buy 30 year treasuries. Buying ensues, yield goes down, price goes up. Eventually 20 year yield becomes greater than 30, as described in purple. Right now for example, you'd get about 3% more yield buying the 20 year VERSUS the 30 year (note: relative yield, not nominal yield), giving us a purple line of 0.968.
The teal line (1.0) is where the relative yields are inverted if the price is below this line. Short term debt pays more than long term debt under this line, which is usually not the case and signals that things are awry.
Now simply repeat this cycle until the rational short term outlook is priced into all irrationally priced long term treasuries. Prices are too low, therefore yields are too high, and rational actors begin buying them. Prices go up, yields go down.
Next up, we have 20Y/10Y (red) at 1.235, which is intriguingly lagging behind the shorter term inversions of 10Y/5Y and 5Y/2Y. If anyone knows why, I would be interested to know! I'm not exactly an expert on debt.
Eventually this cycle repeats until the ratio of short term yields are all very close to long term yields. These conditions always precede a recession, which, by the way, is NOT a well defined term. A recession simply describes "a general decline in economic activity". Not very scientific, is it? Economists utilize a wide range of data to attempt to foresee a recession, yet the outcome is inevitable and uncontrollable. As history shows, any attempt to control the economy and avoid recession (1930s, 1970s) often make things much worse than had policy makers simply let the storm pass initially.
I like to use ratios of yields. Some people subtract the yield of one from the other, which is fine too. I think a ratioized signal is much more pure as ratios rule the world around us. Not only that, given that we're monitoring multiple relative yields, we can get a good overall picture of the current landscape.
Unfortunately there's not much history for the longer term instruments, though as I believe the 30 year has been around for atleast 50 years but only has a few years of TradingView data.
Hopefully the illustrations on this chart along with relative yields help you visualize some of what's happening. I keep this chart of relative yields up ALL the time in a tab! If you have any feedback or comments, I would appreciate it.
Good luck and hedge your bets!
Quick note: In March 2020 not only did the FED setup new centralized repo facilities directly (reverse repo, unprecedented, it's ILLEGAL by the way) and at the same time, engaged in "QE Infinity". In essence there's more avenues at which they are "forced" to buy things that nobody wants. Albeit, they buy it at about market price, assume that's the right price and that they are somehow protecting the economy by pricing in bankruptcy in one asset class and spreading it to the rest of the economy. Belligerent and thoughtless, what more could you want? At the same time, they've sucked a lot of excess cash out of the system once again by offering banks an interest rate of 0.05% for their cash in exchange for some FED junk assets. So suddenly banks are bagholding assets nobody wanted, in order to get interest on their cash, genius huh? OH yeah, and banks are SHORTING those assets on the open market! Effectively making the cash tend towards zero value (the real contract value of those assets which were originally exchanged). Next time something goes wrong, they will unload this ~1.5T diaper of dollars directly into our faces, probably sooner than later, causing more inflation.
Buy 30 year treasuries. Buying ensues, yield goes down, price goes up. Eventually 20 year yield becomes greater than 30, as described in purple. Right now for example, you'd get about 3% more yield buying the 20 year VERSUS the 30 year (note: relative yield, not nominal yield), giving us a purple line of 0.968.
The teal line (1.0) is where the relative yields are inverted if the price is below this line. Short term debt pays more than long term debt under this line, which is usually not the case and signals that things are awry.
Now simply repeat this cycle until the rational short term outlook is priced into all irrationally priced long term treasuries. Prices are too low, therefore yields are too high, and rational actors begin buying them. Prices go up, yields go down.
Next up, we have 20Y/10Y (red) at 1.235, which is intriguingly lagging behind the shorter term inversions of 10Y/5Y and 5Y/2Y. If anyone knows why, I would be interested to know! I'm not exactly an expert on debt.
Eventually this cycle repeats until the ratio of short term yields are all very close to long term yields. These conditions always precede a recession, which, by the way, is NOT a well defined term. A recession simply describes "a general decline in economic activity". Not very scientific, is it? Economists utilize a wide range of data to attempt to foresee a recession, yet the outcome is inevitable and uncontrollable. As history shows, any attempt to control the economy and avoid recession (1930s, 1970s) often make things much worse than had policy makers simply let the storm pass initially.
I like to use ratios of yields. Some people subtract the yield of one from the other, which is fine too. I think a ratioized signal is much more pure as ratios rule the world around us. Not only that, given that we're monitoring multiple relative yields, we can get a good overall picture of the current landscape.
Unfortunately there's not much history for the longer term instruments, though as I believe the 30 year has been around for atleast 50 years but only has a few years of TradingView data.
Hopefully the illustrations on this chart along with relative yields help you visualize some of what's happening. I keep this chart of relative yields up ALL the time in a tab! If you have any feedback or comments, I would appreciate it.
Good luck and hedge your bets!
Quick note: In March 2020 not only did the FED setup new centralized repo facilities directly (reverse repo, unprecedented, it's ILLEGAL by the way) and at the same time, engaged in "QE Infinity". In essence there's more avenues at which they are "forced" to buy things that nobody wants. Albeit, they buy it at about market price, assume that's the right price and that they are somehow protecting the economy by pricing in bankruptcy in one asset class and spreading it to the rest of the economy. Belligerent and thoughtless, what more could you want? At the same time, they've sucked a lot of excess cash out of the system once again by offering banks an interest rate of 0.05% for their cash in exchange for some FED junk assets. So suddenly banks are bagholding assets nobody wanted, in order to get interest on their cash, genius huh? OH yeah, and banks are SHORTING those assets on the open market! Effectively making the cash tend towards zero value (the real contract value of those assets which were originally exchanged). Next time something goes wrong, they will unload this ~1.5T diaper of dollars directly into our faces, probably sooner than later, causing more inflation.
Comment
Here's a chart of reverse repo as explained in the "quick" note at the end of my post ;)Linear chart here, since log scale looked pretty bad with lots of action around the 0 bound.
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