Inverted Yield Curve

What is Inverted Yield Curve?

An Inverted Yield Curve is a phenomenon where short-term bond yields exceed long-term bond yields, leading to an unusual downward slope in the yield curve. In normal conditions, longer-term bonds typically offer higher yields than shorter-term bonds, reflecting the increased risk of holding onto investments for an extended period. However, the inverse yield curve indicates investors expect lower long-term growth or have higher economic uncertainty, driving up demand for long-term bonds. This situation is considered a predictor of an economic recession, as it suggests that investors are more interested in the long-term security of their investments rather than taking risks in the short term.

Understanding Inverted Yield Curves

The yield curve is a tool used to measure the relationship between time to maturity and risk. The 10-year bond is generally used as the benchmark for plotting the yield curve across the world. The X-axis of the yield curve starts with a 1-year bond and goes up to a 30-year bond. As bond maturity increases, so does risk, and investors demand higher returns. Therefore, the yield curve should normally have an upward slope.

For instance, a bond with ten years of maturity will have a higher yield than a bond with five years of maturity. However, the possibility of economic factors such as recession, high unemployment rates, or other factors can cause the yield curve to go downwards. The scenario where the yield curve has a negative slope is referred to as an inverted yield curve.
 

Why does the yield curve get inverted?

An inverted yield curve occurs when long-term bond yields decline more rapidly than short-term bond yields. This happens when the demand for longer-term government bonds, such as the 10-year US Treasury bond, surges compared to the demand for short-term bonds. The increased demand for longer-term bonds drives up their prices, which, in turn, causes the yields to decrease. Conversely, investors sell their short-term bonds to invest in longer-term bonds, causing the prices of short-term bonds to drop and their yields to rise. As a result, an inverted yield curve emerges.

What are the implications of inverted yield curve?

The inverted yield curve is a significant indicator of economic health and can have profound implications for financial markets, especially the stock market. A surge in demand for longer-term bonds, such as the 10-year US Treasury bond, often signals risk aversion among investors, who are seeking a safe haven for their investments amid economic uncertainty. This can lead to a sell-off in the stock market, as investors shift their money away from stocks and towards bonds, which are considered a safer investment during times of economic distress.

Historically, yield curve inversions have often preceded economic recessions, making them a reliable indicator of impending economic downturns. In fact, from the last 40 years, every recession in the US has been preceded by a yield curve inversion. Therefore, when an inverted yield curve occurs, it can create a sense of fear and uncertainty among investors, which can lead to a decline in the stock market.

This was precisely the case when the US yield curve inverted a few weeks ago, causing a significant sell-off in the US stock market, which also impacted other markets around the world. While the US yield curve had been inverted for some time, the 10-year bond yield dipping below the 2-year bond yield in August 2019 created a sense of urgency among investors and spooked markets globally.
 

Should investors be worried?

While an inverted yield curve can be concerning for investors, they should not panic based on rumours or incomplete understanding of the economic situation. Although fears of a potential recession in the world's largest economy are understandable, economic data coming out of the US remains strong, with low unemployment and a robust economy. Additionally, history has shown that there can be a time lag between yield curve inversion recession, spanning from a few months to a few years. Furthermore, not all yield curve inversions have led to full-fledged recessions, but sometimes simply led to an economic slowdown. Investors should remain calm and informed, taking into account the potential impact on different asset classes, particularly equities.

What can an inverted yield curve tell an investor?

An inverted yield curve can signal to investors that the state of the economy is negative and could slide further, potentially leading to a recession and fall in interest rates. As the shape of the yield curve is directly related to the state of the economy, investors can use it as a tool to analyse their investments, particularly in debt, and make adjustments accordingly. By understanding the implications of an inverted yield curve, investors can make informed decisions about their investments to mitigate the potential impact of an economic downturn.

The relationship between instrument price and their yield

The price of a debt instrument in the secondary market is determined by the balance between supply and demand. There exists an inverse relationship between the yield of a debt instrument and its price. For instance, if interest rates in the market rise above the coupon rate of a bond, investors will not buy the bond but instead opt for new bonds that offer higher interest rates. To attract buyers, the bondholder will have to reduce the bond's price, which increases the yield. When the bond's price decreases, the coupon rate increases due to the lower face value, leading to an increase in the bond's yield.

How can inverted yield curves help in forecasting recession?

An inverted yield curve has a significant correlation with predicting upcoming recessions. In the last 50 years, every occurrence of yield curve inversion has resulted in a growth slowdown. Experts and analysts utilise an inverted yield curve as an indicator to forecast a recession. When the previously positive yield curve shifts downward and becomes inverted, it can predict an upcoming drop in interest rates, which is a typical occurrence during a recession. Therefore, an inverted yield curve is a dependable predictor of an upcoming recession.

Historical Examples of Inverted Yield Curves

The historical examples of inverted yield curves include the 1998 Russian debt default, where the 10-year/two-year spread briefly inverted, but interest rate cuts by the Federal Reserve prevented a recession. In 2006, the same spread inverted for most of the year and in 2007, long-term Treasury bonds outperformed stocks. The next event that followed was the Great Recession, which started in December 2007. In August 2019, there was a brief period where the same spread went negative, which was followed by a recession in February and March 2020. This recession was caused by the outbreak of the COVID-19 pandemic.

Why is the 10-year to 2-year spread important?

The 10-year to 2-year spread is important because it is a widely followed indicator that provides insight into the state of the economy. It measures the difference between the yields on 10-year and 2-year Treasury bonds and is seen as a proxy for the yield curve. An inverted yield curve, where the spread is negative, is seen as a warning signal that a recession may be on the horizon. Many investors and analysts use this spread to make investment decisions and anticipate changes in the economy. Some policymakers argue that shorter-term maturities may provide better information on recession likelihood.

Conclusion

An inverted yield curve is an important indicator for investors and analysts to keep an eye on. While it is not a guarantee of an impending recession, historical data has shown a strong correlation between yield curve inversions and economic slowdowns or contractions. As such, investors should pay attention to the shape of the yield curve and adjust their investment strategies accordingly.