Business

The current yield curve: temporary aberration or sign of gloom?

Jamaica must take notice and plan

BY KERMIN HAMIL
Contributor

Wednesday, August 21, 2019

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A very important predictor of future economic activities has been behaving in an abnormal way recently. The recent anomaly evoked fears within the United States of America (US) as well and other countries, sparking fears of future recessions and a downturn in economic activities. The predictor negatively provoked the US stock market in such a way that the Dow Jones Industrial Average (DOW), which is a very important stock market indicator, plummeted approximately 700 points. The predictor, which sent various alarm bells ringing within the international financial community, is known as the yield curve.

To assist with funding budgetary expenditures governments as well as corporations issue bonds.

Bonds are debt instruments, which are in fact promissory notes to borrow monies from the holder/purchaser of these bonds. However, the predominant issuers of bonds are normally governments rather than corporations, as companies have numerous other ways of obtaining financing such as the issuing of stocks, which in most cases cannot be issued by governments.

The bonds, note or bills issued by governments are normally term treasury securities based on their maturities — bonds being longer term, notes being medium term of 2 to 10 years.

To induce investors to lend, governments offer interest on the aforementioned securities. The rate of interest of these debt securities are otherwise known as the 'yield', which is the shortened version for the bond's yield to maturity (YTM). Bonds of different maturities have various rates of interest or yields. The yields can be plotted graphically on the 'y' axis, with different maturity dates on the 'x' axis. Plotting the yields based on various maturity dates and sketching a line through the aforementioned plots is known as a yield curve. The yield curve is a precursor of future economic performances.

DIFFERENT TYPES OF

There are three different types of yield curves: normal, abnormal and flat. Generally, yield curves are upward sloping, which means longer- term bonds provide higher yields than shorter-term bonds.

Yield curves that are upward sloping are known as the normal yield curves. However, the converse is true for abnormal yield curves, which are downward sloping. Meanwhile, the flat yield curve suggests that bond holders are indifferent to bonds of different maturities.

Since recently—August 14, 2019—the US economy has been experiencing inverted yield curves in that, for the first time since 2007, 10-year bonds have lower yields than two-year notes.

To make matters worse, on August 14, 2019 the 30-year Treasury bond yielded a lower rate of interest than the one- month US Treasury bill. In fact, this was an all-time low for the 30-year treasury security at 2.01%.

WHAT I

The yield curve depicts signs of confidence within an economy and, to a larger extent, investors.

The normal yield curve generally indicates that investors are willing to lend on a longer-term basis, but for them to forego current consumption, they will have to be induced by receiving a higher interest rate compared to a lower rate of interest.

If the curve is inverted similarly to what has been experienced in the US, this might suggest that there are signs of uncertainties within the present economy such that investors are in fear of lending on a longer-term basis. In fact, such pessimism to invest or lend requires the borrowers to induce them at a higher rate of interest than what would normally be offered to them.

Reduced confidence level could also impact the stock market while lower confidence levels could trigger panic within the stock markets, which forces investors to sell their stocks even when demand for stocks are low. The imbalances between demand and supply of stock could cause prices to plummet, causing reduced wealth and income levels. Reduced wealth and income levels affect people's ability to demand more goods and services within any economy, affecting the viability of businesses, shareholders' wealth as well as a country's gross domestic product (GDP), all else being equal. A reduction of a country's gross domestic product for three consecutive quarters is technically a recession, which normally increases unemployment, reduces standard of living, and could increase crime and violence.

Recession in the US or Europe will affect Jamaica's GDP, which could trigger a recession locally.

Tourism, remittance and bauxite account for more than 25% of Jamaica's GDP.

Reduction of wealth and income globally cause people to delay travel due to the fact that it is a luxury product. Global recession could cause the Jamaican Diaspora to remit less funds to family members in residing in Jamaica, which in fact would affect the locals' ability to demand more goods and services. Reduction of economic activities globally could affect the demand for bauxite and alumina, causing factories to close, thereby increasing unemployment.

While the early signals could very well be a temporary aberration, history has proved that the last seven inverted yield curves in the US preceded recessions. Therefore, it is important that local policymakers pay keen attention to these symptoms before they become dangerous because as in 2007, countries that fail to plan such as Jamaica will invariably feel the true brunt of a terrible recession, which could be looming on the horizon a few months ahead.

Kerwin Hamil Msc, BBA (Hons), CPA, ABV, CMA, FCA, CGMA, CVA

Programme Director

School of Business Administration

University of Technology, Jamaica-Western campus


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