The appearance of a yield curve inversion has market watchers spooked…
Over the past few months, there has been a great deal of anxious chatter about the possibility of a recession in the US. Arguably, much of this fear stems from what is known as the ‘yield curve inversion’. Historically, yield curve inversions foreshadow a recession.
But what exactly is a yield curve inversion?
In order to understand the phenomenon, a brief explanation of a bond is first required…
Essentially, bonds are how companies and/or governments borrow money from investors. A bond is a contract through which borrowers undertake to pay an investor back, with interest, on a specific date in the future.
The yield (interest) on a bond is in proportion to the risk taken in buying the bond. Because companies and governments that sell bonds want to lock in long-term financing, they promise a higher yield to investors who lend money over a long period.
If, for example, you buy a bond in which a company or government promises to pay you back over 10 years, your yield should be higher than that of investors who only lend money for one year. So, lending money over a long period is an indication that the investor has faith that a company/government will be in good shape 10 years hence.
For example, looking at Treasury bonds (debt sold by the US Federal government) investors are lending the US government money over three time frames, namely: 3 months; 2 years; and 10 years. Yields on 10-year Treasury bonds should always be higher, because of the long period attached to these bonds. Investors rightly expect to be compensated for the added risk they are taking by owning long-term bonds.
However, over the past few months, yields have been higher on shorter dated US Treasury bonds (i.e. 2 year bonds). This means that buying US Treasuries for only 3 months, for example, paid more than keeping them for a decade.
The phenomenon of being paid more for a short-term loan than a long-term loan to the US government is known as the inverted yield curve, i.e. an upside-down version of what is generally the norm!
Markets react badly when this happens, because when the yield curve has inverted it indicates that investors have little confidence in the near-term economy…and that the dark shadow of recession is approaching.
Source: Anchor Capital