Why are Investors Getting Spooked by an Inverted Yield Curve?

In the past week, the American investors witnessed an inverted yield curve for the first time since the year 2007. An inverted yield curve is one of the most tell-tale signs that a recession is around the corner. This is the reason why the sighting of the yield curve sent both the equity as well as the debt markets in a frenzy.

In this article, we will understand what a yield curve is, what an inverted yield curve is and what the history behind these curves is.

What is a Yield Curve?

American treasury bonds are considered to be the safest investments in the world. This is because the American government is the most powerful financial institution in the world as of now. American treasury bonds have the full faith and backing of the American government. Hence, they are seen as being infallible given the current financial order.

The interest paid by these treasury bonds is known as the Treasury yield. Now, the American Treasury department issues a wide variety of bonds with different maturities. There are bonds issued for a three month period as well as ones which are issued for thirty year periods. The respective yields of all these securities are mapped on a graph sheet. The resultant curve is called the yield curve since it signifies the yield that the investors will get on their investments based on the time that they have invested their surplus for.

It needs to be understood that the treasury yields serve as a proxy for interest rates. Hence, an increase or decrease in the Treasury yield has an effect on almost every investment in the market place.

What is an Inverted Yield Curve?

Under normal circumstances, investors expect to be compensated more if they invest their money for a longer duration of time. This is the reason why the yield curve is normally in a gently upward sloping position. When interest rates for greater maturities are higher as compared to lower maturities, the yield curve is said to be steep.

On the other hand, when near term interest rates are higher than long term interest rates, the yield curve is said to be inverted. The yield curve is a reflection of the expected interest rates in the market. Hence, the inverted yield curve suggests that investors are demanding more interest rates in the short term than they are in the long term. This means that the investors are first expecting a cash crunch to take place in the short term. However, in the long term, these investors are expecting central banks to interfere and bring down interest rates.

Why do Inverted Yield Curves Exist?

The primary reason behind the existence of inverted yield curves is the fact that the drivers behind short and long term security are different. Short term securities are driven by the rates being set by the Fed. On the other hand, longer-term securities are driven by inflation expectations in the future.

Hence, when central banks are aggressively raising interest rates, the inverted yield curve appears. It means that investors want to be compensated more in the short term because of the rates which are being set by the government. On the other hand, investors are willing to be compensated less in the long run since they believe that the raised interest rates will subdue inflation over the long term.

What does an Inverted Yield Curve Signify?

Historical data suggests that an inverted yield curve is almost a sure shot sign that a recession is just around the corner. Over the past 50 years, this indicator has turned out false just once.

The short term cash crunch which has been mentioned above is often the real reason why the recession begins in the first place. When interest rates rise, businesses shelve their plans for expansion. Consumers also postpone big purchases. Hence, the economy as a whole slows down.

This process tends to take some time. As a result, the inverted yield curve is a signal that a recession may occur within 12 to 24 months.

Why this Inverted Yield May not Result in a Recession?

As soon as the inverted yield curve was sighted, panic spread across equity and bond markets. As a result, many experts have started warning against the panic. The experts are of the opinion that the fundamentals of the United States economy are still pretty strong. Since the employment numbers, inflation, etc. are all under control, it is unlikely that a recession may be around the corner. Analysts at companies such as Goldman Sachs have also explained that the inversion in the yield curve is not as steep as it used to be during previous recessions. It is true that the yield for ten-year bonds did fall below the yield for three-month bonds. However, it is still higher than the yield for two-year bonds.

All analysts agree on the fact that there is not going to be a stock market boom in the near future. However, they do not expect negative returns either. According to them, the next few years will see slow and muted growth. However, the growth will still remain in positive territory.