The Yield Curve Inversion Explained
Simple answers to the intricate economics behind the inversion of the yield curve
The yield curve again inverted — this time between 10-year and 2-year US Treasuries. Unlike 10-year/3-month spread, the recent inversion is considered a reliable indicator of the recession, which usually occurs 21 months after the event. Bridgewater Associate’s Ray Dalio estimates that there is a 40% probability of a recession in 2020.
For us, it is worth explaining in the simplest possible way what is the yield curve and what is so frightening about its inversion.
What is the yield curve?
The yield curve is a curve that demonstrates the yields (or interest rates) of bonds with different maturities (maturity date is the date on which the issuer of the bond has to pay, in addition to interest rates, the bond’s original value).
Normally, interest rates on short-term bonds are lower than long-term — after all, in the long run, the probability of inflation, war, crisis, etc. is higher than in the nearer term, and therefore investors demand higher yields on long-term bonds than short-term.
What is the yield curve inversion and why is it so scary?
Typically, interest rates on long-term bonds are higher than near-term. The inversion of the yield curve occurs when yields on short-term securities suddenly become higher than long-term, or, put differently, interest rates on long-term bonds fall below interest rates on short-term.
Why does this happen?
First of all, it is important to understand that bond prices and yields move in opposite directions — that is, when the demand for a bond increases, interest rates on it fall. This is because the issuer of the bond can offer lower interest rates since there are enough people willing to buy the bond.
Another way to understand why bond prices and interest rates have an inverse relationship is this.
Let’s imagine that the US government issues Bond A worth $1000, time to maturity 10 years, and 2% yield. Consequently, the US government will pay the purchaser of this bond $20 each year and $1000 after 10 years.
And now imagine that the demand for 10-year Treasuries rises. What would happen? Well, in order to obtain a 10-year bond, each investor will offer more favorable conditions to the US government — that is, each investor will ask for a lower yield so that the issuer of the bond sells it to them rather than other people.
Ultimately, as we see, the higher the demand for a bond, the lower the yields.
What impact does higher demand have for the inversion?
More than 90% of the time the spread between 10-year and 2-year Treasuries is positive (meaning that interest rates on 10-year bonds are higher than interest rates on 2-year). However, as can be seen from the graph above, there are times when the spread is negative — that is, 10-year bonds have smaller yields than 2-year do. Furthermore, it can be also inferred that the inversion precedes every recession by, on average, 21 months — recessions are indicated as shaded areas in the graph.
When investors feel that the recession is coming, they seek safe assets for their investments — usually long-term US Treasuries. 10-year Treasury bond is considered the safest investment in the world. Therefore, when there are fears of a recession, investors increase their demand for 10-year US bonds. The 10-year yield can be lowered to such an extent that it ends up below the short-term yield — leading to an inverted yield curve. So we can think of the inverted yield curve as an indicator of investors’ sentiments about the future of the economy and the risks of a recession.
This is why the inversion of the yield curve is considered an indicator of the recession.
