What is an inverted yield curve

What is an Inverse Yield Curve? Explanation and impact

As a trader of a Macro-FX strategy, we pay attention to hints and signs from the fundamental data. There is currently more and more news about an inverse yield curve. Find out why this is important for the stock and forex markets here.

As a trader or investor, you want to get the right warning signals at the right time.

One of those red flags is an inverse yield curve. Now let's take a look at what is behind it and why it is relevant for traders in all markets.

What are Treasuries?

US Treasuries are bonds or debts that are sold by the US government, most of which pay a fixed interest rate over a period of time, ranging from a month to 30 years.

They are considered to be the safest securities in the world because they are backed by the full belief and approval of the US government.

What are Treasury Returns

Treasury yields, also known as yields, are a measure of the annualized return an investor can expect on holding a government bond to maturity. They also serve as a proxy for the interest rates.

The rate of return is determined by the price of the bond in relation to the stated interest rate. When bond prices rise, yields fall.

 

What is the Treasury Yield Curve?

It is a plot of the returns for all treasury maturities, ranging from 1 month to 30 year bonds.

Under normal circumstances, it curves upward as investors expect bonds to be more compensated for taking the additional risk of owning bonds with longer maturities. A 30-year bond typically brings more than a 1-month bond or a 3-year bond.

If the yields further outside the curve are significantly higher than those near the front, the curve is said to be "steep". So a 30 year bond will provide a much higher return than a 2 year note.

When the gap or "spread" is narrow in bond market jargon, it is called a "flat curve". In this situation, for example, a 10-year bond may only offer a slightly higher return than a 3-year bond.

 

What is an Inverse Yield Curve?

In rare cases, the yield curve no longer falls completely or partially upwards. This happens when shorter-dated returns are higher than longer-dated returns and are referred to as "inversion".

 

This week, the yield curve inverted for the first time in more than a decade, when the yield on 5-year bonds fell below that of 2-year and 3-year securities.

The rest of the curve is still sloping upwards, although the curve has flattened overall for some time.

 

Why is the inversion important?

The reversal of the yield curve is a classic signal that a recession is imminent.

The US curve has reversed in the last 50 years before each recession. It only sent the wrong signal once during that time.

When the short-term returns exceed the longer-term, it signals that the short-term financing costs are more expensive than the longer-term financing costs.

In these circumstances, companies often find it more expensive to fund their business, and managers tend to mitigate or defer investments. The cost of consumer borrowing is also rising and consumption, which accounts for more than two-thirds of the US economy, is slowing.

The economy eventually shrinks and unemployment rises.

How quickly does the recession hit?

It has taken the economy between 12 months and 24 months to fall into recession if the yield curve reverses.

Also, the curve reversal often ends before a recession begins.

A reversal of the yield curve has no power to predict the length or severity of a downturn.

Why is the yield curve reversing?

Shorter-term securities are very sensitive to the interest rate policy of a central bank like the U.S. Federal Reserve.

Longer dated securities are more affected by investor expectations of future inflation, as inflation is anathema to bondholders.

So when the Fed hikes rates, as it has done for three years, it will push yields on shorter-term bonds up at the top of the curve. And if future inflation is viewed as contained, as it is now, as higher borrowing costs are likely to weigh on the economy, investors are willing to accept relatively modest returns on long-dated bonds at the lower end of the curve.

This dynamic is currently taking place, so that the curve is flattening and possibly reversing even further than before.

The stock markets have already reacted and, in combination with the US-China trade dispute, have caused stock exchanges to fall sharply.

It remains exciting ...


 

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