facebookWhat does it mean when the yield curve of bonds invert? Why does it usually precede recessions? - Seedly

Anonymous

07 Jun 2019

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General Investing

What does it mean when the yield curve of bonds invert? Why does it usually precede recessions?

AMA The Fifth Person

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Hi anon, the basic idea behind the yield curve is that it shows the yield (or in layman terms the rate of return if you bond the bond to maturity) for bonds of different lengths of maturity BUT the same level of risk. this means you won't be comparing bonds rated BBB- in one emerging nation with Singapore Treasury bonds rated AAA. On the yield curve, they are of the same risk level and rating.

As you should know, the yield and price of the bond are inversely related- a rise in demand for a particular bond will lead to a rise in price, and less need to have higher rate of returns to attract investors to buy the bond, thus a fall in yield. Thus, when the yield curve inverts, this means that the Short term, 3 months Treasury bills are in less demand than 30 year bonds. What this means is that investors are expecting the interest rates (or target Fed fund rate) to be cut in the near future - meaning less yield of bonds, meaning rise in price. Investors see this as a sign of locking in the good interest rates now so that they can capitalize on cut interest rates in the future by trading the bonds away, or just holding it to maturity for above the future rate's interest payment.

But why is this so important? it indicates that the economy is slowing down and having a potential recessionary gap - inflation is a non-issue to the federal reserve or central bank because the economy's output level has slack - showing that growth is slowing. Thus, in order to boost the economy Feds usually will cut interest rates to entice people to consume and invest more.

Inversion usually show extremely pessimistic outlook of investors for the future, as they think that the economy is about to tank pretty hard and are digging in heels by locking in the current rates that may not be reached again in the near future. It is an strong, albeit not perfect indicator of the state of the economy, and may indicate that the business cycle has reached the peak and is looking to head down to the trough.

Examples of inversion of yield curves for Gov Treasuries - US 2008 Recession.

Examples of inversion that did not/ or have not, preceded a huge recession - December 2018 yield curve inversion. But this of course, is yet to be seen.

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In a simplistic explanation:

Normal yield is 'rising curve' - rate is higher the longer the duration. Becos people expect higher rates the longer the lock-in duration.

'invert' just means that any of rates of the long term are lower than its shorter term. This is becos investors might expect recession or deflationary environment ahead. They would rather accept a lower rate (guaranteed) than risk losing in stocks or other vehicles. Therefore demand for the longer term bonds increases, pushing down yield.

Victor Chng

21 Feb 2019

Co-Founder at Fifth Person Pte Ltd

Hi,

The inverted yield curve compare the short term bond yield to the long term bond yield. If sho...

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