Sunday, April 22

Inversionary jitters in bond yields

In the usual course of business, investors expect more compensation for greater risk. All other things being equal, long-term bonds carry more risk than short-term bonds from the same agent. As a consequence, investors typically expect a greater yield on long-term bonds than short-term bonds.

When yields for longer-term bonds are lower than short-term bonds, you need to ask why. Some consider yield curves a canary in the economic coal mine. One explanation might centre on short-term expectations around official interest rates. Another might focus on the underlying health of the economy.

Bloomberg publishes a regular report on the latest Australian Government bond yields. In the current report, the yields from 3 months through to 3 years are clearly declining. We have a partially inverted bond yield curve. This decline is broadly consistent with the ASX target rate tracker implied yield curve.

However, those of you with a keen eye will note that the ASX implied yield curve is trending up from around 12 months out, but bond yields are dropping through to 3 years. The difference suggests that while the short-term inversion in bond yields is about market downward expectations on official interest rates, the inversion at 2 years and 3 years is driven by other considerations.

In the following charts we look at yield curve inversion in these longer-term bonds. In part, we are looking here because this data is readily available from the RBA (table f02d). But in part, yield inversion in these medium term rates can demonstrate significant nervousness in the long-term prospects for the real economy.

In these charts, we accumulate the absolute difference in percentage points when the three year Australian Government bond yield rate is less than the two year rate; when the five year rate is less than the three year rate; and/or when the ten year rate is less than the five year rate.

While no where near the scale of nervousness that preceded the GFC, we are seeing slight inversions (perhaps micro-lumpiness might be the better term) in medium-term bond yields at the moment.

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