Before we get into the details of how to interpret the inversion of the yield curve, let us first see what a yield curve is and what it represents.
The yield curve is a graphical portrayal of yields on comparable bonds over an assortment of developments. An ordinary yield curve inclines upward, showing that short-term interest rates are typically lower than long-term interest rates. That is an effect of higher hazard premiums for long-term ventures.
An inverted yield curve represents a circumstance where long-term debts maintain lower yields than short-term debts. An inverted yield curve will mean that short-term interest rates are higher than long-term interest rates.
There are three fundamental curve types, including the inverted yield curve, which is considered as the rarest of the three. It is viewed as an indicator of an economic downturn. As the inversion of the yield curve is quite rare, it often catches the attention from all spheres of the financial realm.
To understand the inversion of the yield curve, you must first know about bonds.
The inversion of the yield curve is closely related to the yields on the treasury bonds or government bonds.
A bond resembles an IOU that you receive at a bank. When you deposit money at the bank, it will give you back that equivalent sum later, along with a fixed measure of interest.
For instance, given that you spent $100 for a two-year bond with a 2% yearly profit on it, it will imply that you will receive $104.04 two years later. It is a low return rate, but bonds have various advantages that legitimize the low return rate.
- Extremely Stable Investment
Stable investment is particularly evident with regard to government bonds. You cannot lose your cash with government bonds except when the government defaulted on its advances, which is a rarity.
- Guaranteed Return
Bonds guarantees return, so you will have knowledge of the amount you are getting on your return on investment when you buy a bond.
- Longer Investments Yield Higher Returns
The more you wait on your bond, the higher return you will reap as longer bonds gives higher return rates.
In a typical yield curve, the short-term bonds yield lesser returns than long-term bonds. Speculators anticipate a lower return rate when their cash is bound for a shorter time. They need a better return to give them more profit for a long-term investment.
The inversion of the yield curve occurs when speculators have little hope in the near term economy. They request a higher yield for a short-term venture instead of a long-term investment.
They see the near term as more hazardous than the far off future. They would want to purchase long-term bonds and bind their cash for a considerable length of time despite the fact that they get lower yields. They would possibly do this only when they feel that the economy is deteriorating in the near future.
The Meaning Of An Inverted Yield Curve
There are twelve types of bonds that the US Treasury Department sells such as, One-month, two-month, three-month, and six-month bonds, One-year, two-year, three-year, five-year, and 10-year bonds, and 30-year bonds.
When an inverted yield curve arises with Treasury yields, it becomes a concern as short term yields become higher than long term yields.
An inverted yield curve implies that speculators feel they will get more by getting a long term bond rather than a short one.
With short term bonds, they recognize their need to reinvest within a few months. Once they see a recession approaching, they will except a fall in the value of short term bonds as the Federal Reserve brings down the fed budgets rate when the economy hampers.
Why the Yield Curve Inverts
But why is there an inversion of the yield curve?
One primary reason for the occurrence of an inverted yield curve is because of the investors who sell their stocks and shift their cash to bonds. As they lose hope in the economy, they start to believe that the low rate of returns from bonds will be a better option than incurring potential loss during a recession. In this way, the demand for bonds rises higher than the yields.
This sweeping loss of hope in the economy solves why inverted yield curves have occurred each downturn since 1956. The last inversion of the yield curve started in December 2005 and foreshadowed the Great Recession, which formally started in December 2007, followed by the financial emergency in 2008.
When investors turn more to long-term bonds, the yields drop. As they are in high demand, they do not require high yields to draw the attention of investors. When the need for short-term Treasury bills declines, they have to pay a better return to draw in investors.
In the end, the yield on short-term bonds goes higher than the yield on long-term bonds, and this is why an inverted yield curve occurs.
If the investors see a recession is looming, they will prefer a safer form of investment and will avoid maturities lesser than two years. This lowers the demand of those bonds while raising their yields and thus, creating an inverted curve.
The Aftermath of an Inverted Curve
Although the inversion of the yield curve has effectively flagged recessions for the past five decades, the economic recessions can occur as late as 34 months later, as indicated by a Credit Suisse report. In general, markets rebound about 15% after the inversion of the yield curve.
Inversions may, in general, spur market sell-offs on the day they occur, the foreshadowing usually comes months before the actual recession.
An inverted yield curve may be used to predict recessions in the economy, but it cannot be entirely relied on.
An inversion of the yield curve does not necessarily mean that there is an impending recession. There could be other reasons for an inverted curve such as an anomaly, or the high short term rates by the Federal Bank.