Rajandran R Founder of Marketcalls and Co-Founder Algomojo. Full-Time Derivative Trader. Expert in Designing Trading Systems (Amibroker, Ninjatrader, Metatrader, Python, Pinescript). Trading the markets since 2006. Mentoring Traders on Trading System Designing, Market Profile, Orderflow and Trade Automation.

What is Yield Curve Inversion? How it matters for Investors?

2 min read

If you recently heard about the term Yield Curve Inversion in TV channels, News or Social Media probably the analyst/journalist are referring to US Treasury Bond Yields. US Treasury Bond Yields are issued by the US government.

Why it is so important to track the Yield Curve Now?

Yield curve inversion is a sign that an economic contraction could be on the way. Many believe that the yield curve is the leading indicator for the economy. The yield curve is a reliable predictor of future real economic activity.

US Treasury Bond Yields for Different Maturity

Yield Curve inversion between
 3-month and 10-year U.S. yields

The last time such an inversion has occurred was 2007, about a year before the global financial crisis. And so the Global equity market reactions on last Friday. The spread between 3-month and 10-year U.S. yields goes negative on last Friday which is referred to Yield Curve Inversion

Generally speaking bond value and bond yields have an inverse relationship. If the bond value goes up then that means the bond yields go down and vice-versa.

What is a Yield Curve?

Yield curve is essentially a summary of yields across the spectrum of maturities in the bond market from very short term to very long term.

Treasury Yield Curve Rates are commonly referred to as “Constant Maturity Treasury” rates, or CMTs. The CMT yield values are read from the yield curve at fixed maturities, currently 1, 2, 3 and 6 months and 1, 2, 3, 5, 7, 10, 20, and 30 years.

If one plots Bond Maturity on the X-Axis and Yields on the Y-axis we get a Yield Curve. Normally the yield curve slope upwards, means the long term bonds pay higher interest rates than the short-term bonds.

because if you are going to tie up your money for a longer period of time, usually as an investor, you’re going to want more for the compensation for the risk that you’re talking so those long-term bond yields tend to be higher.

Now it isn’t the case the yield curve is always sloping upwards. There are times when inflation is falling and long-term yield rates may come down relative to short-term yield rates and vice-versa.

The yield curve doesn’t always slope upwards sometimes it changes it shape for example the curve for time to time has been known to flatten and when that happens investors tend to believe recessions on their horizon.

How the Yield Curve Flattens?

Naturally, a flat yield curve is cause by either by the short term yields increasing or the long term yield falling. The Federal reserve (FED) have lot of influence on the short term bond yields. But the long term bond yields are harder to control.

If more people start buying long term bonds it will cause the long-term bond price to increase and so the drop in long term yields. That flattens the yield curve. In other words, investors believe that some greater risk is out there. May be the investors expect the future interest rates to fall which makes short term bonds less attractive or they expect other investments to perform poorly. Both of these come from the expectation that the economy is likely to slow down.

Yield curve inversion is clearly a sign that the market is worried about growth and moving into long term Treasuries from riskier asset classes.

Yield Spread between 3-month and 10 year Treasuries
Source : Bloomberg

The difference between the short term rates and long term rates is the proxy for bank lending profitability. Banks tend to borrow at short term rates and lend at long term rates, and so they can earn the yield spread.

And then the yield curve inverts or goes negative it becomes less profitable for the banks to lend and that tends to slow down the economic activity, because consumers aren’t able to get mortgages to buy houses or auto loans and business aren’t able to get loans to expand their business, and it can lead to a recession, which is why investors get very concerned about the flattening yield curve or yield curve inversion.

Here is the simple explainer from wall street journal about Why Investors Are Obsessed With the Inverted Yield Curve.

So what do you think? Recession is ahead ?

Rajandran R Founder of Marketcalls and Co-Founder Algomojo. Full-Time Derivative Trader. Expert in Designing Trading Systems (Amibroker, Ninjatrader, Metatrader, Python, Pinescript). Trading the markets since 2006. Mentoring Traders on Trading System Designing, Market Profile, Orderflow and Trade Automation.

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