Of the last nine recessions, the bond yield curve correctly predicted nine of them (or ten, if you count the economic slowdown in the mid-’60s). There isn’t any other economic indicator that has that success ratio.
So when people talk about a bond yield curve inversion, investors usually pay attention.
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Why You Should Care About an Inversion in the Bond Yield
If you’re able to predict when there will be a recession, by default you can predict when there won’t be a recession. For example, if the yield curve is not inverted, then presumably the risk of a recession in the near term is low.
Now, of course, this applies to the US economy. This is because the bond yields we talk about are specifically those in the US. However, since the US is still the world’s largest economy, what happens there will have knock-on effects around the world.
What Is the Bond Yield Curve?
The US government issues bonds with different maturities. Those that mature in less than a year are called bills. On the other hand, those that mature between 1 and 10 years are called notes. The ones that mature after that are called bonds.
The government can issue any kind of maturity. However, they usually repeat the same pattern: 30 days, 90 days, 1 year, and all the way up to 30-year bonds. The yields on those bonds vary depending on different economic factors at the time.
If you plot the yields of all these bonds in a graph, you get what mathematicians call a “curve.” However, most of us would call it a line. Often it’s curved, but not always and not necessarily.
Under normal circumstances, the yield should be higher the longer the bond maturity. This is because the longer you must wait to get paid back, the more uncertainty there is. Treasury bills—the shortest ones—will, all things being equal, have a lower yield than notes. And these will have a lower yield than bonds that mature past 10 years.
An Inverted Yield Curve Means the Yield on Bills Exceeds the Yield on Notes
An inversion happens when the normal situation (that is, an ascending curve) inverts. The happens when shorter-term bonds (bills) have a higher yield than long term bonds (notes). The angle of the slope isn’t as important as the inversion of the logic behind each bond’s yields. When shorter-term bonds have higher yields, it means investors expect rates to be lower in the future.
This happens because as the Fed raises rates during a growing economy, it pushes the whole yield curve higher. But, bond yields could go down soon. Why? Because when there is a recession, the Fed cuts rates in a desperate attempt to get the economy going.
Thus, if investors expect a recession, the yield for notes drops in anticipation of lower interest rates during and following the recession.
It’s not unusual for some of the curves to invert, depending on the ebb and flow of demand. But, the classic definition of an inversion is when the yield on bills exceeds the yield on notes.
Why You Might Not Care About an Inverted Yield Curve
Nothing is perfect, and just because something worked in the past, it doesn’t mean it will work again in the future. The predictability of the yield curve was determined in the late ’90s and got widespread notice after the ’08 recession.
Now that everyone is aware of it, though, the market might behave differently. That’s because investors will try to “get ahead” of the market. Additionally, the Fed expanded its balance sheet significantly during the last credit crunch. This was an unprecedented move. It now is in the process of selling off extra treasuries, which might cause distortions in the yield curve.