[Song Seungseop's Financial Light] Inverted Long- and Short-Term Interest Rates and Economic Recession

Short-term bond yields move with the base interest rate
Long-term bond yields influenced by 'future economic outlook'
Global recessions have occurred each time of yield curve inversion

Finance is difficult. It is filled with confusing terms and complex backstories intertwined. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and consistently follow the flow of money, a foundation of financial knowledge is essential. Accordingly, Asia Economy selects one financial issue each week and explains it in very simple terms. Even if you know nothing about finance, you can immediately understand these 'light' stories that turn on the bright 'light' of finance for you.

[Asia Economy Reporter Song Seungseop] The gap between long-term and short-term bond yields in the United States has widened significantly. The media continues to report this as a 'sign of crisis.' But why does the interest rate difference occur depending on the bond's maturity? Why is the interest rate difference considered risky and a sign of crisis?

The longer you lend, the higher the cost

The word bond (債券) is composed of the characters for debt/liability (債) and certificate/contract (券). It is a certificate created to document that a company, country, or individual has borrowed money. Simply put, it is a document formalizing a debt. Bonds specify how much was borrowed, the interest rate to be paid, and the repayment deadline.

So, which bonds have higher interest rates? There are several factors, but 'duration' is an important one. What if someone borrowed money from you and promised to repay it the next day? You probably wouldn't be very worried. You can get your money back after just 24 hours. But what if they said they would repay in one year? You might think, 'What if something happens during that year and I don't get my money back?' The risk of losing your money is higher with long-term bonds. Therefore, interest rates are generally higher for long-term bonds.

Of course, the boundary between short-term and long-term is not clear-cut. For some, even a day is a very long time, while others think a year passes quickly. In economics, one year is generally used as the standard to distinguish short-term and long-term. For important global economic indicators like U.S. bonds, 10-year and 2-year bonds are examined to differentiate long and short terms. In Korea, comparisons are sometimes made between 3-year bonds and 91-day bonds.

Why do long-term and short-term interest rates change?

[Image source=Yonhap News]

So how do long-term and short-term bond interest rates change? Simply put, it is supply and demand. When many people buy long-term bonds, their prices rise, causing yields (interest rates) to fall. Conversely, when many short-term bonds are supplied, their prices fall, causing short-term bond yields to rise. Supply and demand are influenced by numerous variables such as liquidity in the market, credit ratings, issuance volume, and more. Interest rates also change according to the benchmark interest rate. Since bonds are issued with reference to the benchmark rate, when the benchmark rate rises, bond yields also increase.

However, there is one problem. Long-term and short-term interest rates do not always move at the same pace. The benchmark interest rate applies equally to all economic agents, but long-term and short-term bonds are affected differently. Imagine the benchmark rate is raised by 0.5 percentage points to 3%. A U.S. bond maturing in one year would likely be significantly affected. Bond investors would expect that the U.S. interest rate will be around 3% in one year, so bond yields would need to be about that level to be attractive. Therefore, short-term bond yields are said to move significantly with the benchmark rate.

But long-term bonds are different. Can you predict what the U.S. benchmark rate will be 10 years from now? The U.S. might implement a near-zero interest rate policy to stimulate the economy, or it might do the opposite. The current benchmark rate hike has relatively little impact on rates 10 years from now.

The worse the economic outlook, the lower the long-term bond yields

Source: Korea Development Institute (KDI)

Therefore, investors try to speculate on the economic situation 10 years ahead. If the economic outlook is good, people sell stable bonds and buy stocks with higher returns. As bond demand decreases, bond prices fall, causing bond yields to rise. Conversely, if the economic outlook is bleak, investors buy stable bonds. Unlike stocks, bonds clearly state how much interest will be paid and until when, so when the outlook is gloomy, investors buy safe bonds. When bonds are bought like this, bond prices rise (bond yields fall).

Supply factors also have a significant impact. When the economic outlook worsens, how do companies behave? They are unlikely to issue bonds. Would any company borrow money by issuing bonds when the economy is uncertain? If the supply of long-term bonds decreases, their prices soar. This means long-term bond yields have dropped sharply. To summarize, when the economic outlook is good, long-term bond yields rise; when the outlook is bad, long-term bond yields fall.

What happens when long-term and short-term bond yields move at different speeds due to different factors? A 'yield curve inversion' occurs, where short-term bond yields are higher than long-term bond yields. When the benchmark rate is raised quickly, short-term bond yields rise sharply, but if the economic outlook is poor, long-term bond yields rise only slightly or even fall. As mentioned earlier, since interest rates are generally higher for long-term bonds due to the longer lending period, it is normal for long-term bond yields to be higher than short-term yields.

The market takes the inversion of long-term and short-term bond yields very seriously. First, when the yield curve inverts, the economy can actually worsen. This is because financial institutions reduce fund supply. Banks and other financial institutions raise money by issuing bonds and then lend that money out. Specifically, they raise funds through short-term bonds but provide loans over long periods, sometimes for decades. So what happens if short-term rates are high and long-term rates are low? They raise funds at a high cost but face reduced net interest margins or losses. Therefore, financial institutions become reluctant to supply funds, and if this situation persists, the risk of a credit crunch increases.

Economic recession follows long- and short-term rate inversion

A statistic indicating that an economic recession (gray shading) occurred when the spread between long-term and short-term interest rates fell below zero.

Above all, when long- and short-term rates invert, a major economic recession has followed. According to analysis by the Capital Market Research Institute, since 1962, the U.S. has experienced seven recessions, and in six of those cases?excluding the 1960s?an inversion of long- and short-term rates was observed. The actual recession began 5 to 23 months after the first inversion. Significant inversions occurred during the 1980s oil shock, the 2000s dot-com bubble burst, and the 2008 global financial crisis.

Recently, the inversion between long- and short-term rates has become pronounced. As of the 25th, the yield difference between Korea's 10-year and 3-year bonds was -0.067 percentage points, meaning short-term bond yields are higher than long-term yields. On the 23rd, the U.S. long- and short-term yield difference was -0.076 percentage points. Considering that during the 2008 financial crisis the difference was -0.011 percentage points, this is a significant increase.

Bloomberg reported earlier this month, "The long- and short-term yield difference has never been this extreme since 1981," adding, "Historically, an inversion of long- and short-term yields signals a path toward economic recession."