For professional investors talks about inverted yield curve is common, but for most ordinary people such phrase is a complete abstraction. Let’s try to figure out what it is and why they talk about it so much? And why it can be inverted? The answer to the last question is in the word called a recession.
What exactly is this inverted yield curve
The inverted yield curve is a value showing yield or interest rates for different bond issues. Usually, the longer bond maturity date (longer it’s circulation period), the higher yield of such bond is.
In some ways, it resembles a bank deposit. The longer the term of deposit, the higher is the rate. For example, when you deposit cash for three years, you have the right to expect a higher yield than when you deposit funds just for 6 months.
Why is that? You put your funds at greater risk by placing them for a long time, therefore justify higher returns, if there is no general market reduction in the future.
Another example, if we take 2-year bond with 2% to pay, and 5-year bond with 2,5% payable, then in total the yield curve will have 0,5%.
Thus, a curve is the same as credit quality. This can be seen in the cases when bonds are absolutely identical in terms of their conditions, and their only difference can be in the maturity date and in profit.
It is possible to shape a yield curve from different bonds. Although best known today benchmark shows yields comparison of U.S. Treasuries on 2-years, 5-years, and 30-years. So that is about what most of the experienced economists talking in their inverted yield curve discussions.
U.S. Treasury serving is a very important and perhaps evens critical indicator. This is because a fact that most banks and large financial funds and organizations, as well as many governments, take these indicators into account in their calculations. Today it is believed that U.S. Treasury is the safest investment haven. The level of assurance that you will get a certain return on your investment is very high and without much risk. The interest rates of this financial instrument are universal and can change their values in a fairly narrow framework since this is due to the high security of the bonds themselves.
At the same time, if situation in the financial markets develops in a negative way, the yield may show significant growth and Treasuries have to raise interest rates in order to compete with other investment instruments. And in case of a positive situation of development in the American economy, a value of yield will decrease.
When something went wrong
However, sometimes, markets are under pressure from adverse factors, while curve reflects these changes. Sometimes bonds with long-term rates may be same as rates on short-term issues. This is a plane yield curve.
Sometimes yield on long-term bonds falls below short-term, and then yield curve becomes inverted. These contain an indication for markets concern and in general for the international development.
How curve can change
It can be constructed for any bond, but there is one specific curve, around which most of the talk in media is conducted.
The State bonds is issued by the US Treasury to finance its activities. This curve shows a difference in returns between ten years and two years issues, which historically is an indicator of the health status of the economy and markets.
And despite the fact that this curve looked “normal” since the financial crisis of 2008, it is now gradually smoothed out. In 2012, a difference in ten years and two years bonds was 1.95%. Today, this difference is only 0.25%!
Why is it so important
There are different opinions on what the current inverted yield curve may mean for markets.
Lots of experts who say that this time situation is different from the classical one. As a justification, they cite the fact that economy is predetermined. Moreover, this is not the first case when dynamics of the markets did not conform to the “pattern” of crisis behavior.
In any case, reason why the inverted yield curve has become such a frequent topic of conversation, is simple: it often precedes recessions in the United States! it often precedes recessions in the United States!
And this may lead to a situation where demand for bonds with longer-term investments will increase over short-term placements. Investors will seek more security. There can be also bigger worries over money-losing and even the possibility of obtaining a good profit is hardly considered by people and funds.
This has happened more than once and there is no guarantee that it will not happen in the near future. You can recall how this occurred in the recent past. During recessions, inverted yield curve reached negative values of 2-year treasuries in relation to the 3 and 5-year-olds. And if take as an example such years as 1978 or 1988, we can see that then treasuries could foreshadowing recessions. Only once in a recent history curve has strongly dipped, but this did not last longer than a month, then yield curve fully recovered and went into positive values.
When a new crisis will start this time
The time lag between spread going in the negative zone and the beginning of the recession, ranged from 6 to 24 months, according to the Federal Reserve Bank of San Francisco. However, now the situation has not reached a critical point. The spread has greatly decreased but remains positive. Consequently, time must pass to form a fully invested yield curve. Therefore, many economists estimate a probability of a recession on the horizon to be less than 20%. Many other indicators telling about continued economic growth. However, investors are frightened by the prospects for ending effect of tax incentives and trade wars.
In the first half of the year, American economy was spurred on by Donald Trump’s initiatives. However, with the growth of the Fed’s rates, positive factor began to dry up. Interim congressional elections have increased political split, so it will be harder for Trump to promote his fiscal initiatives.