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An inverted yield curve is used to predict disaster. That’s right! Do you want to use this tool to predict a recession? Find out how below.
We already have a post on the yield curve. Read it here.
What is an Inverted Yield curve?
It represents a situation where long term debt instruments invested yield lower returns than even the short-term debt instruments of the same credit capacity.
We all know that long-term debt instruments have higher risk rates. This makes their yield higher. However, where a situation occurs that makes its return lower than the short-term instruments, we say the graph has an inverted yield curve.
Although investors require higher yield for a higher risk investment, under abnormal circumstances when they believe that the economy will run into a recession they will accept a lower yield.
In addition, an inverted yield curve shows that the market believes that inflation will remain low. For instance, during inflation, we know that prices of goods and services increase. People will tend not to invest in long term instruments as they are in need of liquidity. The yield for it will increase but because of factors like quality, currency, the yield will reduce.
Although this rarely happens, when it does, it indicates that there or an impending economic recession.
Understanding Inverted yield curve
In a normal yield curve, the short-term yield is usually lower than the long-term yield. That is to say, you get a smaller amount for giving out your money for a short period and a higher return for a long time.
When this normal flow ceases, it means that investors do not have confidence in the economy to leave their funds for longer periods. They believe that the economy is getting worse in the near future than in the far future.
Why does the Yield curve invert?
When many investors start investing in long term bonds, the yields on them fall. This is typical in every market. In this period, they are in demand so they do not need a high yield to attract investors.
However, the demand for short-term bonds are low, so they need to pay a higher yield to attract investors.
So, if investors perceive an impending recession, they go for investment with maturities of less than 2 years. This inverts the yield curve because, from the statistics, recession lasts for an average of 11 months.
Currently, the yield curve inverted in February 2020. The yield on the 10-year note fell to 1.59% while the yield on the one-month and two-month bills rose to 1.60% due to the pandemic.
The curve is gradually worsening. By March 9, the 10-year note had fallen to a record low of 0.54%.
Example of a case of an Inverted yield curve
A great example happened in 2005 in the US when the federal fund rate was increased to 4.25%. This caused the two-year Treasury bond yield to 4.4% while the seven-year bond gave 4.3%.
As time went on, the curve began to invert some more as the recession began approaching and investors continued to invest more heavily into longer-term bonds.
Eventually, the county experienced a recession.
In 2019, the yield curve also briefly inverted. There were signals of inflation, interest rates were also increased by the Federal Reserve. This inversion of the yield curve signalled the onset of recession during 2020.
In conclusion, to understand how yield curve inverts, you’ll first understand bonds.
Here’s a little recap
- Bonds are safe investment options. A typical bond is the one offered by banks for a return.
- It is always a safe option for people who do not feel confident in the market.
- If more people invest in bonds, their return rate goes down.
However, take an inverted yield curve as a sickness. More like an indication of a recession and a subsequent market crash.
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