Could someone explain the interest rate difference

Interest rate differential curve

What is an interest rate differential curve?

An interest rate differential curve shows the difference between the yields on short-term and long-term bonds. Usually, the yields of bonds with two and ten year terms are chosen for this. If an interest rate differential curve turns into positive territory, this is a sure early indicator of an impending recession.

Current situation - 03/2021

The interest rate differential between US government bonds with three months and 10 years maturity was -1.66 percent in March 2021, even lower in the negative normal range and 18 basis points above the -1.48 percent in February. Important: higher interest rates for bonds with longer maturities should be the rule, which is why the difference between short-term and long-term interest rates is usually negative. In the past, the persistence of the interest rate differential curve in positive territory in 8 out of 10 cases was the harbinger of a recession.

The interest rate differential between 2- and 10-year US government bonds is also still in the negative "normal range" at -1.54 percent at the end of March 2021, after -1.40 percent in February. The interest rates for bonds with a shorter term are also lower than the interest rates for bonds with a longer term.

We still see one reason for the still flat interest rate differential in the low interest rates in Europe and Japan, which are generating strong demand for today's higher-yielding US government bonds. This causes their prices to rise and thus depresses the return. Investors are looking for so-called "safe havens", ie safe bonds, and are therefore taking refuge in US bonds that still have positive interest rates, despite falling yields.

The inversion of the US yield curve in January / February 2020 is therefore not based on weaker economic growth, but on sustained high demand for US bonds from abroad.

In Germany, the interest rate differential between 2- and 10-year government bonds remained unchanged at -0.40 percent in March 2021 compared to the previous month. However, it is still in the negative area defined as normal, in which the difference between short-term and long-term interest rates is negative.

Interest rate differential curve for German government bonds

The interest rate differential for German government bonds with a term of two and ten years as a long time series from 1972 - based on the return data from the Deutsche Bundesbank. As a second data set, we have inserted the change in gross domestic product (GDP) for Germany to show you how accurately the interest rate differential curve predicts a decline in economic growth. Every intersection of the zero line of the interest rate difference from negative to positive was followed by a significant decline in economic growth at intervals of a few months up to two years.

Operating note: Individual data series can be hidden and shown again by clicking on the relevant heading.

Swell:

Change in GDP in Germany

Operating note: Individual data series can be hidden and shown again by clicking on the relevant heading.

Swell:

Interest rate differential curve for US government bonds

Interest rate difference between 2- and 10-year government bonds

The interest rate differential for US government bonds with two and ten year maturities as a long time series from 1976 - based on the return data from the Fed St. Louis. We have also inserted the change in gross domestic product (GDP) for the USA as the second series of data to show you how accurately the interest rate differential curve predicts a recession. Every intersection of the zero line of the interest rate difference from the negative to the positive area or an approximation to less than 0.20 percentage points was followed shortly thereafter by a clear decline in economic growth.

Operating note: Individual data series can be hidden and shown again by clicking on the relevant heading.

Swell:

Operating note: Individual data series can be hidden and shown again by clicking on the relevant heading.

Swell:

Interest rate difference between 3-month and 10-year government bonds

In its capital market forecast for 2019, the investment company states Green Fisher Criticism of the often used interest rate differential curve between 2- and 5-year government bonds, as the 5-year interest rate is no more a suitable period for long-term lending than banks refinance themselves over 2-year interest rates. Green Fisher According to the significantly better comparison of the 10-year interest rates for long-term runners and 3-month interest rates or overnight interest rates for short-term refinancing. We are happy to take up this idea and publish below the interest rate differential curve between US government bonds with three months and ten years maturity, based on data from the Fed St. Louis:

Operating note: Individual data series can be hidden and shown again by clicking on the relevant heading.

Swell:

Normally, the yield on ten-year government bonds is based on the economic growth of the respective country or currency area. A decline in the return is therefore an indication of a weakening of the economy and thus of economic growth to the same extent.

In a world where the bond markets are controlled by the central banks, this rule no longer applies. Historically low government bond yields in Europe and Japan are generating strong demand from abroad for higher-yielding US government bonds. This demand is causing bond prices to rise, with yields falling, conversely.

Therefore, an inverse interest rate differential curve, as we observed in March 2019 for 3-month and 10-year US Treasuries, is currently not a reliable indicator of an impending recession.

What is the interest rate differential normally?

Normal case = negative interest rate difference

Normally, the difference between the yield or the interest on bonds from the same issuer with a term of two and ten years is negative. The creditor who lends money to a debtor over ten years usually wants a higher interest rate than if he only lent the money for two years.

Exception = interest difference 0 or positive

If an investor expects the economy to slow down, the interest rate differential can turn positive. The mechanism behind it is explained relatively simply: if the economy of a country or economic or currency area weakens, the demand of companies for loans decreases. The central bank then usually cuts the key interest rate in order to stimulate demand for credit.

Investors who expect this scenario will try to secure the currently higher interest rate for as long as possible. To do this, he buys long-term government or federal bonds.

The increased demand for these bonds causes their prices to rise and thus their yields to fall, which is thus approaching the interest rate level of short-term bonds.

If the return on long-term bonds falls below that of short-term bonds, this is a sure sign that investors are afraid of a recession.

Yield on 2-year bonds minus yield on 10-year bonds> = 0 -> signal for imminent recession

Interest rate differential as a leading indicator

Since the yields on bonds and the resulting interest rate differential are one to a maximum of two years ahead of the actual development of the economy, the reversal of the interest rate differential can be used as an early indicator of a recession.

A look back shows that this indicator predicted the two major downturns on the stock markets this millennium.

In both February 2000 and June 2006, the interest rate differential curve for US government bonds turned positive, so bonds with a two-year term yielded more returns than those with a ten-year term. The legendary crash from March 2000 to October 2002 and the crash in the context of the financial crisis from August 2007 followed with a short delay.

And the inverted interest rate differential curve in September 2019 was followed by a drop in gross domestic product growth of -5.00 percent in the first quarter of 2020, almost on the foot.

As an investor, you should always keep an eye on the interest rate differential curve. A falling yield gap between short-term and long-term government or federal bonds is not a problem in itself. If the distance approaches the mark of zero percent, you should be careful.

If the gap increases into positive territory, it is advisable to focus your own investments defensively in the economic or currency area concerned. Switching from stocks to fixed-term deposits could be a good idea, so that you don't have to forego safe and, above all, fixed interest rates during the recession.

Stock market development and interest rate differential

We have learned that an inverse interest structure, i.e. the crossing of the zero line of the interest rate difference between short and long-term bonds, is an indicator of an impending recession. But how does the stock market actually react? To answer this question, we compared the annual development of the Dow Jones and the S&P 500 with the interest rate differential curve for US government bonds:

Operating note: Individual data series can be hidden and shown again by clicking on the relevant heading.

Swell:

Note: The information on the annual performance of the Dow Jones and S&P 500 has been reduced by a factor of 10 so that the development over time in relation to the interest rate differential rates is more visible!

Dow Jones and S&P 500 reaction

For all inverse interest structures in the USA since 1989, we also looked at the development of the Dow Jones and the S&P 500 in the following 12, 24, 36 and 60 months:

  • In eight out of nine cases, the indices were above their previous year's values ​​12 months later.
  • In seven out of nine cases, the indices were also above the values ​​at the time of the inversion 24 months later.
  • In six out of nine cases the indices were below the values ​​at the time of the inversion 36 months later, but:
  • In seven out of nine cases, the indices were again above the values ​​at the time of the inversion 60 months later.
Date of the inversion of the interest structurePerformance of the Dow Jones
12 months later24 months later36 months later60 months later
31.01.198910,60%16,82%37,62%69,85%
30.06.199822,55%16,71%17,32%0,37%
29.02.20003,62%-0,22%-22,09%6,30%
28.02.200611,60%11,58%-35,75%18,30%
30.06.200620,25%1,79%-24,24%11,34%

Date of the inversion of the interest structurePerformance of the S&P 500
12 months later24 months later36 months later60 months later
30.06.199821,07%28,29%7,98%-14,06%
29.02.2000-9,26%-19,01%-38,44%-11,92%
28.02.200611,05%3,87%-42,63%3,77%
30.06.200618,05%0,61%-27,64%3,81%