The Yield Curve and Interest Rates: What Do They Mean?

If you’ve been paying attention to the markets or the media lately, there has been a lot of talk about the yield curve.

What is the Yield Curve?

Simply put, the yield curve is a graph that plots the interest rate yields of bonds over time. Usually, longer maturity bonds have a higher yield than shorter maturity bonds because investors are compensated with higher returns for tying up their money for a longer period of time. However, in March of this year, the yield curve inverted for the first time since the financial crisis of 2007/08. This means that a shorter-term bond has a higher yield than a longer-term bond. One year ago, the yield on a Canada 10-year government bond was 0.91% (or 91 basis points) above the rate on a 3-month Treasury bill. In August, it was around 40 basis points below (see chart). For many economists, an inverted yield curve has historically been one indicator of an impending recession.

Does This Mean a Recession is in Sight?

There’s an old joke that says the markets predicted nine of the past five recessions. This is to say that predictions are often more pessimistic than what happens in reality. Of course, as long as we have a business cycle, every recession prediction will eventually be correct, it’s just the timing that is often wrong.

Yield Curve diagram

While it is true that global economic growth has slowed, these are unprecedented times. Never before have central banks held interest rates at these low levels for such long periods of time. In July, the U.S. lowered its overnight interest rate for the first time in over a decade, citing slower global growth and uncertainty from U.S./China trade tensions. Here at home, interest rates have held steady, due to a variety of bright spots: over the summer Canada’s productivity, measured by GDP and trade surplus, posted surprising growth; employment still remains at historical highs; and many companies have posted positive results.

Negative Interest Rates: The New Normal?

In some parts of Europe and Japan, negative interest rates have continued for years. Central banks have kept overnight rates negative to dissuade commercial banks from maintaining large deposits with the central bank, and instead encourage them to lend to businesses and consumers who will spend funds. This is to try and boost economic activity, growth, and inflation.

What Does this Mean For Investors?

Equity markets can react favourably to lower interest rates. As finding income in fixed income products becomes more difficult, investors may look to more risky assets like equities. However, slowing global growth is expected to impact equity markets, and growing global indebtedness continues to be a concern; the future consequences of which are not fully understood.