Yield Curve Inversion — What’s the fuss?

Historic yield curves.
Historic U.S. treasury yield curves (Wikipedia)

So you’ve most probably been bombarded with apocalyptic rantings over the Yield Curve Inversion — So what’s the deal with the infamous yield curve, and its inversion?

Lets start with an introduction to what yield curves are, and thence to its infamous inversion.

Treasury Bills and the Yield Curve

The yield curve referenced is the amount of interest that investors receive from the U.S. government in return for lending the latter money. This occurs in the form of buying U.S. treasury securities, a debt obligation instrument issued by the U.S. Department of the Treasury in conjunction with the Federal Reserve Bank.

A 1969 U.S. Treasury Bill (Wikipedia)

These Treasury securities come in the form of Treasury bills (for debt maturation under one year), and Treasury notes (with maturities ranging in: 2, 3, 5, 7, and 10 years). Thus, the yield curve graph shows how much interest investors collect for holding treasuries of differing maturation dates.

In other words: How much compensation they want from the government for lending it money for a certain duration.

In most cases, investors demand higher returns for lending their money for longer. This is because long-term securities usually carry more risk.

Yield curve inversions of 2006/7 and 2019

Treasury Yield Curve Inversion

Having established what treasuries and the yield curve are — what then is yield curve inversion?

Yield curve inversion occurs when the yield on short-term government debt is higher than that of long-term debt.

Why would this happen? The answer is that investors expect a recession.

When the economy starts slowing down — and especially as the government implements quantitative easing and makes borrowing money cheaper, investors flee from stocks and move their investments to long-term government bonds. Belief that the dollar is weakening can have a similar effect. This increased demand for long-term bonds means that the bond yield sinks.

Thus, yield curve inversion is a strong signal for a looming recession.

Both the dot-com and 2008 crashes were preceded by yield-curve inversion — and a similar pattern holds for all major U.S. recessions since 1950.

3 month, 6 month, 2 year vs. 10 year yield graphs (python plot based on Fed data)

Which Inversion Matters?

Since inversion is measured as longer term treasuries providing a lower yield than short-term ones, the question is: which exact short and long-term yields are these calculations based on?

The Federal Reserve bases its calculations on the 3 month and 10 year treasuries, while Wall Street has gravitated their focus instead to 2 year and 10 year bonds.

The difference in focus is due to the two year yield inversion signalling possible financial troubles earlier than the three month yield, while the latter gives a more definitive sign of economic malaise.

What Does the Current Inversion Mean?

Treasury yields vs. Quarterly GDP growth. Python plot based on OECD data.

We have all heard it, as of 2019 the yield curve has inverted. So does this signal a recession? Opinions are mixed. GDP growth has not dropped significantly, though consumer spending and disposable income have. Some experts further hypothesize that the yield-curve inversion has been due to capital flight from Europe and Asia due to their slowing economies.

In any case, a yield-curve normalization should not be seen as a sign that the danger is over — most yield-curve inversions are followed by an uptick in the S&P500 as well as the yield-curve, followed by a recession.

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