The Yield Curve Inversion
Updated: Jan 18, 2021
As you’ve probably heard by now on all financial media outlets, the yield curve has finally inverted which has been attributed as the main cause for the market selloffs. But what is the yield curve anyway? What does the inversion in it mean? And why is this inversion so important?
To start at the most basic level, the yield curve is the plots of the yields of the same bond (in this case US treasury bonds) using different maturities where under normal circumstances bonds with longer maturity dates should yield more than shorter maturity dated bonds because of the added future uncertainties which in turn demand a higher risk premium. After all, why would an investor lock up a sum of money for 10 years instead of 2 years if they have the same yield?
Dissecting the factors that influence the yield on different bonds:
In general, the shorter end of the curve (2 years and less) is more or less influenced by the federal reserve and the monetary policy in general, while longer-term bonds are more influenced by GDP growth expectations and inflation expectations.
When the yield curve inverts, on the other hand, it means that shorter maturity bonds are yielding more than the longer ones, wherein our current environment the 2-year Treasury bonds started yielding more than the 10-year Treasury bond.
Then why does the yield curve ever invert? This question has several theories, but in general, this signals that investors are nervous about future growth which also reflects that they think that currents rates are too high and they expect them to be lower at a future date as a result of the weaker growth.
Worth noting that even though the yield curve has historically been a good recession indicator, it has never been instant. In fact, recessions have followed yield curve inversions anywhere between as little as 7 months to over 2 years, or in some instances, like 1995 and1998 the yield curve has inverted but the fed intervened and cut rates (similar to this year) and a recession didn’t follow through. Is it different this time? It is quite possible that the unusually low rates for the past decade have distorted the yield curve which might possibly mean that it will not be as accurate as of the usual. Worth noting also the negative interest rates around the world (-0.99% in Switzerland, -0.70% in Germany, etc..) might also have weighed on the yield of the 10-year treasury as foreign investors started flocking to them.