Yield curve 101
If you read the financial press, you’ve probably come across journalists worried about the so-called ‘flattening of the yield curve’ and what that process tells us about the direction the economy is headed. Wednesday morning, for instance, Bloomberg ran a story with the headline “The Yield Curve is Flattening Relentlessly,” and Reuters warned that “Yields slide on US threat of Syria attack.”
But what is the yield curve, what does its shape mean, and how does it affect trucking and logistics in the United States? The yield curve is a way of comparing the returns on a standardized form of debt, for example government bonds, over a period of time. Normally, the yield curve slopes upward the longer the contract duration, because longer-term debt is inherently more risky and therefore offers a higher return than short term debt.
It’s vital to remember that for bonds, price and yield move inversely: if I have a bond that pays 1% and I bought it at 95 cents on the dollar, I’m getting about a 6.3% return. If that bond becomes more attractive to investors for whatever reason, the trading price of the bond might rise to 99 cents on the dollar, and then that same 1% bond would yield roughly 2%. So as the price moves up against the coupon, the yield contracts. The more desirable a bond, the lower its yield becomes (which is why unsecured corporate debt rated lower than ‘bbb-‘ by Standard & Poor’s, commonly called a ‘junk bond’, offers high yields).
When the yield curve is normal, short-term government bonds, which carry very little risk, have lower yields than longer-term government bonds (because who knows if the federal government will default on its debt in the next 30 years). The yield curve flattens when short term yields rise relative to long term yields or long term yields fall relative to short term yields, or both, as has happened in the past 6 months for U.S. government bonds. A simpler way to visualize the yield curve is to just take the spread between 2 year and 10 year Treasury bonds, and also the spread between the 5 year and 30 year Treasury bonds: the smaller the spreads, the ‘flatter’ the curve. Check out the graph Bloomberg published Wednesday morning:
“You could have shorter term yields rising relative to longer term yields because of near term fears of inflation or longer term fears of poor growth,” said FreightWaves chief economist Ibrahiim Bayaan. “In this case I think it’s the former, but it’s a problem either way because it reduces incentive for banks to lend. The other reason long term yields might be held down is because of money coming in from foreign investors.”
Janet Yellen, the last Fed chair, said last December that the flatness of the yield curve did not signal a recession. “Right now the term premium is estimated to be quite low, close to zero, and that means that structurally, and this can be true going forward, that the yield curve is likely to be flatter than it’s been in the past,” Yellen said.
In the first case cited by Bayaan, short term fixed income becomes less attractive if investors believe that there’s a short term inflation risk: if dollars become less valuable, your fixed returns are worth less. As the price of those bonds drops, the yield rises. In the second case Bayaan mentions, recession fears—an expectation of low or no growth for years into the future—means that investors want to lock in rates on long-term debt, and they rush into 10 and 30 year bonds, driving up the price and shrinking the overall yield. In the current economic climate, short term inflation fears seem to be a stronger driver of rates, with 2 year Treasuries rising 80 bps in the past six months and 10 year Treasuries falling 17 bps in the past month.
The cost of debt
We’ve established that the flattening yield curve is really an indication of investors’ perceptions about different kinds of risk in the future. One of the effects of a flattening yield curve—the shrinking spread between yields on short term debt and long term debt—is that banks are dis-incentivized to loan money. Banks ‘borrow short’ and ‘lend long’, meaning that they borrow customers’ deposits and from other banks and the Fed and pay very low short-term rates: these rates are set by the Fed. Then the banks lend money to consumers in longer term loans for houses and cars at a higher rate, to cover the risk of default over what can be decades, in the case of a home loan.
When the spread between short and long term debt tightens, banks have less room to cover their risk. For instance if the short term rate the bank borrows money at is 1.75%, and the long term rate they lend it at is 2.25%, they’re only making .50% annually, and that may not be enough profit to cover the risk on a years-long loan. So, the banks respond in two ways: they start gradually raising interest rates on long-term mortgages for homes and cars, but more immediately they become much more selective about who they lend money to, only approving the very safest borrowers.
So, in a flattened, and especially in an inverted yield curve environment, credit seizes up and loans become more expensive to obtain. The flattened yield curve’s effects on the trucking industry stem from this increased scarcity and cost of debt.
New truck financing, payments factoring, and used truck prices
Scarce and expensive credit will drive up the cost of financing to purchase new trucks and and the cost of factoring payments. Large carriers will pay marginally higher rates for new truck loans, but it’s really the smaller carriers and owner operators who might have trouble obtaining credit. Right now, the yield curve is the flattest it’s been in 10 years, but actual inversion, where short term yields exceed long term yields, is taken as a predictor of a recession. The rule of thumb is that an inverted yield curve occurs about a year before the recession takes hold. In a general economic downturn, the transportation industry’s downside risk will also make banks less likely to lend to small carriers and owner-operators; i.e., lower demand (freight volumes) in a recession make it more likely that smaller outfits default on their loans.
Rising short term yields and falling long term yields make the yield curve flatten. Sometimes short term yields rise because investors anticipate the Federal Reserve to increase federal fund rates, the overnight interbank lending rate. The idea is that if you’re holding a bond paying 1% and everyone expects coupons to rise to 2%, you have to sell your bond at a discount so the buyer gets the same yield she’d get by purchasing the new bonds. So short term yields rise when investors think rates are about to rise.
The Federal funds rate does not directly affect the cost of factoring. Factoring is a short term, high yield product; factors commonly charge carriers 2% ‘off the shelf’ to buy their receivables, which translates to about a 24% APR. Meanwhile, factors are borrowing money from banks at the prime rate, which this week is 4.75%, plus about 4%, for a total cost of about 8.75%. So the factors are taking the spread of nearly 16% annualized interest between their cost of borrowing and their fees. Now, if the Fed raises its annual rate by .25%, and a factor raised their annual APR to 24.25% to match it, that would only raise the typical factoring fee to 2.02% from 2%. Because factoring is so high yield, and so short term, the small–even substantial–increases in the Fed’s annual rate are largely diluted by the time they make it back to the carrier in the form of fees.
Lastly, there are a couple of ways that a flattened or eventually inverted yield curve might affect used truck prices. A flattening curve will tend to raise the cost of financing used trucks. If the economy actually rolls over into a recession, demand (freight volumes) will drop, some small fleets may go out of business, and the supply of used trucks will increase. Meanwhile, banks will tighten credit, discouraging buyers and putting further downward pressure on prices. Finally, the average age of large carriers’ fleets will rise as they put off costly capital expenditures. As the economy comes out of the recession, used truck prices rise because the large fleets will offload their older, but relatively well-maintained trucks. That’s what happened following the Great Recession of 2008-9, according to FreightWaves’ historical data on used truck prices.
We are, of course, not at the point of calling a recession, but a flattening yield curve has negative effects on credit, liquidity, and economic activity all by itself.
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