Why is Everyone Talking about the Inverted Yield Curve?

Heard of – Yield Curves at least somewhere across financial media? Or perhaps you don’t even know what we are talking about. Regardless, yield curves are in spotlight recently. Hopefully in next 5 minutes if you continue reading, you will know a lot about it too. Ask why should you go on? Well, yield curves can help you predict the future. Sort of.

What is a Yield Curve?

Yield curve is believed to be an indicator. And certain movements in its shapes signal good or bad news to come. Now, before we proceed to the advanced stuff, let’s breakdown what Yield curve is.

A yield curve is the graph you get by plotting the interest rates at which a borrower can take loans, for different time periods. While any borrower can have a yield curve, the yield curve that everybody in the market watches is that of the government of the country.

Moods of the Yield Curve

Take Indian government for example. It borrows money from the market through auctions of treasury bills and government securities from time to time. Now, when you plot its yield curve, you draw a graph through current market interest rates and its borrowings. This graphs basically show how much interest is getting paid in the short-term and long-term.

What Do These Curves Foretell?

Some compare 2-year, 10-year US treasury yield curve, while some follow 10-year and 3-month. It depends. Usually, longer-term bonds offer higher yields than shorter-terms, which is depicted by upward sloping curve. It is obvious as you will naturally demand higher interest to lock away your money for longer, given the risk of inflation.

But a curve can go flat when the rate on 30-year bonds is not different than the rate on 2-year ones, suggesting a sluggish economy. It can be steeply upward sloping curve, like the one we’re seeing in India, is a sign that markets expect interest rates to rise sharply in future. This rise can come about due to inflation rising, economy reviving, etc.

But a curve can go flat when the rate on 30-year bonds is not different than the rate on 2-year ones, suggesting a sluggish economy. It can be steeply upward sloping curve, like the one we’re seeing in India, is a sign that markets expect interest rates to rise sharply in future. This rise can come about due to inflation rising, economy reviving, etc.

But there could be times when investors are worried that the economy will fall sharply and are willing to accept less for the bonds maturing in future than in the short-term. This is what market watchers call ‘inverted yield curve’. And when this happens, market starts getting nervous. This is what is exactly happening in the US.

Why Has the Curve Inverted in the US?

Market watchers see inversion of yield curve as an alarm for an impending recession. That seems to be the case in current times. Yields of short-term US government bonds has risen quickly this year, while longer-dated bond yields have moved at a slower pace.

As a result, the shape of the US Treasury yield curve has been generally flattening and in some cases inverting. This yield curve inversion further stoked fears of recession among investors. Inverting has led to recession in the past too.

An inverted yield curve appeared in December 2005 and signalled the Great Recession, which officially began in December 2007. Then came the 2008 financial crisis. There was also an inversion before the tech bubble burst in 2001. Similarly, in 2019, the curve again inverted. In early 2020, the pandemic did, in fact, trigger a recession. As you would’ve noticed, there’s often a lag of 6 to 18 months between the curve inversion and stock market downturn. In the meantime, stock markets tend to perform positively.

Should You Be Worried?

All these charts and yield talks are tough to digest. Should you really worry about the current inverted yield curve phenomenon in the US? Of course, if the US goes into recession, that is not good for anyone. It can hamper growth and has implications on the economy and markets.

The bottomline is that the yield curve may or may not be the perfect indicator. It can give false signals as well. Hence, you as an investor should therefore, not panic. Inverted yield curve and its implications notwithstanding, at the end of the day investors should stick to their financial goals and invest according to their financial plans.

References: The Indian Express

CNBC

Investopedie