An inverted yield curve is when short-term government bond yields become higher than long-term ones. In the United States, United Kingdom, and Japan we saw this phenomenon observed. According to some economists, inverted yield curves have preceded almost every recession during the last 50 years.
Of course, other economic factors can contribute to a recession. However, this curve is often considered one of the first signs that a recession might be around the corner. An inverted yield curve is a term used by economists to describe when the yields on bonds with different maturities have inverted. In other words, if you buy a three-year bond and a 10-year bond on the same day, their respective yields should be roughly equal. If they’re not, something is going on in the economy that might not necessarily be bad.
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The Inverted Yield Curve
A yield curve is a graph that shows interest rates on bonds with similar credit qualities. Different maturities are plotted against their respective maturity dates.
A normal curve slopes upward where long-term credit quality is higher than short-term credit quality, thus giving investors an incentive to take more risk for greater rewards over the longer term.
Conversely, an inverted curve happens when short-term bond yields are higher than long-term ones. Or long-term yields are lower than short-term ones.
In an inverted yield curve setup, short-term rates are higher than long-term. While this situation isn’t particularly good for investors who hold debt securities, inverted curves can offer clues about what’s going on in the economy.
Periods of recession have been correlated with inverted yield curves. However, inverted yield curves have flattened out over the past few years, likely due to central bank policies holding down interest rates.
Why Does an Inverted Curve Happen?
An inverted yield curve is defined as inverted when the interest rate on short-term Treasuries is higher than long-term ones. Regardless of inflation. There are many reasons why these curves happen. Still, they generally happen when investors lose hope of economic recovery anytime soon. Or if they feel like there isn’t enough growth potential left in the global economy.
Inverted yield curves also indicate that investors lose faith in the leading central banks to keep inflation under control. This is a very negative signal about the economic future. An inverted yield curve happens during periods of low growth.
When there’s an economic slowdown, investors prefer to keep their cash in safe investments like bonds to avoid losing money. Because they expect little return on their cash, they accept a lower yield on short-term bonds.
The Fed
Generally, the Federal Reserve raises interest rates when economic growth is strong. As a result, longer-term bond yields increase more than short-term ones. Which causes the yield curve to “invert.” This means that the shorter end of the curve starts paying less yield than its longer peer.
Similarly, when economic growth is weak, the Federal Reserve cuts interest rates. And short-term bond yields decrease more than long-term ones.
A yield curve inversion is a good predictor of a future recession. However, it doesn’t guarantee one will happen. On the other hand, when economic growth has been strong for an extended period, it can lead to inflation. As a result, it sets off a regime change at the Federal Reserve. The Fed is likely to respond by raising interest rates to control inflationary pressures.
As they do this, short-term yields will increase more than long-term ones, which causes the yield curve to invert. This means that the shorter end of the curve starts paying more than its longer peer. As a result, when economic growth is weak for an extended period, there isn’t enough demand for credit.
This can lead to deflationary pressures. This prompts the Federal Reserve to lower interest rates to stimulate investment and spending.
Why Do Traders Pay Attention to It?
This curve is a very powerful indicator of negative sentiment among market participants. They’ve been shown to precede almost every recession. Therefore, they’re a good way for analysts and traders to prepare themselves for upcoming business cycles or even financial crises. Why? The inverted yield curve has been proven to be a predictor of these events.
Many investors consider inverted yields as a sign of an incoming recession because inverted yields generally mean lower demand for loans from consumers. And businesses and lower capital mean less growth which ultimately results. Producers, manufacturers, and consumers are sensitive to their short-term borrowing costs. Therefore, an inverted yield curve has a large impact on individuals, businesses, and government institutions.
Moreover, this curve can cause a sharp drop in stock market prices. In fact, inverted yield curves have been the most reliable predictor of recessions, according to some economists.
Implications
According to some economists, the inverted yield curve has been the only reliable predictor of recessions. But that doesn’t mean all curves lead to all recessions. Inverted yield curves are often considered one of the first signs that a recession might be around the corner. As a result, the curve isn’t a perfect predictor. However, it still provides information for traders, investors, and economic watchers.
The inverted yield curve implies that investors are very pessimistic about future economic activity. Since short-term rates are higher than long-term rates, people are more willing to tie up their money for a longer period at lower interest rates than the current rate on short-term bonds.
Therefore, if they think interest rates will increase soon, they wouldn’t be interested in buying short-term bonds that may have less value when higher interest rates return. An inverted yield curve is usually caused by an upcoming recession or financial crisis, which hurts company profits and erodes consumer spending power keeping inflation low.
The Bottom Line
Bonds are great investment tools. In fact, the government uses bonds for most of its investments. If you can call that government investing. But we all want to see a heads up of a recession right? Then we can trade and invest in a way that protects us from losing money. Unfortunately, that isn’t possible.
Otherwise, we’d all be rolling in the dough. But knowing how to invest in safe havens protects you when the market moves down. We all know that what goes up must come down. So at some point, this crazy market will reverse.
