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What is an inverted yield curve and what does it really mean?



If you follow the markets, you probably know that the yield curve is partially reversed. You probably also know that this is a pretty big deal because almost every financial reporter in the country keeps saying that. It may not be so obvious why exactly everyone is freaking out about it.

The answer is in a word recession. The chances are good that one is emerging.

Here's what's going on.

What is the yield curve?

The yield curve compares the yield of various bonds of the same credit quality over time. It shows otherwise identical bonds on the basis of their different maturity dates in order to report the short-term yield compared to the medium or long-term maturity.

For example, if a two-year AAA bond paid 1

% and a five- If AAA bonds paid 1.5%, it could represent a yield curve of 0.5.

The curve compares the same credit quality, because if the bonds are identical, only the return varies over time.

You can build a yield curve from any set of bonds, but the most common benchmark is the chart, which compares the returns on three-year, two-year, five-year, ten-year, and 30-year US Treasury bonds. This is what economists refer to when they discuss "the" yield curve.

This is because US Treasury debt is a critical indicator. Banks (and even some governments) use it as a universal store of value. It's the safest place to invest, because despite recent political turmoil, you're almost certain that your investment will pay for itself.

The key interest rates rise conversely in investor confidence. If banks and investors feel good about the US economy, returns will rise. They are confident of putting their money into other sectors, such as mortgages and corporate loans, so government bonds must pay higher interest rates to compete. However, when confidence fades, investors are more likely to look for a safe place to spend their money. Government bonds offer a unique form of security, which reduces their returns.

What is an inversion of the yield curve

OK, now you know what a yield curve is and why we follow the key interest so carefully. [19659002] Well, what's the big deal with "inversion"?

Typically, the yield curve follows a predictable course in which long-dated bonds outperform short-term bonds. Basically, the government pays more money to borrow more money. This is called a "positive" yield curve because the difference between a long term and a short term return is positive.

Short-term bonds, however, will occasionally generate more returns than long-term ones. Term ones. The curve becomes negative. This is what is known as the "reverse" yield curve.

That's what happened on Monday. Both two-year and three-year bonds began to pay more than five-year bonds. Ten-year bonds are also on their way to where the markets are most concentrated – in periods when the two-year Treasury is more than the ten-year earnings.

This means that longer-dated bonds are in demand now exceeds the demand for short-term instruments. Investors have begun to prioritize long-term security over access to capital. They are more concerned about losing their money than missing out on an opportunity.

That does not happen often. Historically, this happens only in very specific situations: just before the beginning of a recession. The yield curve was negative in the years 2005/2006, 2000, 1988 and 1978, when recessions predominated, with respect to the two-year, five-year and three-year Treasury. The only exception was in 1998, when the yield curve plummeted for a month or two in the summer without causing a recession.

For this reason, economists consider the yield curve to be a reliable leitmotif for future recessions. This does not mean that the market collapses immediately. Normally, inversion goes back a year or two. So, if the historical patterns prove true, the economy will eventually turn at the end of 2019 or 2020.

It is important to note that this is a correlation, not a cause. Bond prices are not leading to a recession. They only signal how bankers see the market. (Indeed, you see our own Katherine Ross, why you might not panic yet.)

Other Recession Indicators

A reversal of the yield curve would normally be enough to freak economists out by themselves. In this case, however, the yield curve hits some other red flags.

For several years, economists have warned of a renewed recession if they are to blame for no other reason. Recessions usually occur every eight to ten years, and the last one hit in December 2007.

Stock prices have also created a lot of fear. As the Dow Jones Industrial Average has risen sharply in recent years, many market watchers warned of a possible overvaluation. In principle, investors are too enthusiastic and pay more than the underlying assets are worth. When this happens, the market eventually corrects.

What do you know? The stock market is after a few losses this year in an increase of 1,000 points. On Tuesday, the dollar hit most major currencies. Oil prices, which have been rising since the Second World War before any recession in the US, spent most of 2018 forecasting an increase. The cryptocurrency market, while relatively small, has lost 85% over the last 12 months and has lost more than $ 630 billion. Announcements for the dismissal have already begun, especially in the auto industry.

Economists have long warned against the current guidelines of the government. The undeclared trade war, begun by Donald Trump with most of America's trading partners, has shaken investors and industries alike. Despite efforts by the government to ease the pressure of higher prices, core sectors such as agriculture and manufacturing are reporting that business is slowing down and General Motors (GM) employees have confirmed that the company's layoffs are based on tariff-driven steel prices.

The Challenge of Responding to Recessions

When this recession occurs, there may not be many tools in the box.

In recent years, the government has used up the resources it would normally use to fight a recession. Although interest rates have risen, they have been low by historical standards since 2008. The Fed usually responds to a downturn by using interest rates as an incentive to lend, but at the moment there is not much to save.

Government spending would be constrained by US $ 21 trillion in public debt. While the textbook economy recommends that Congress buy and sell the private market during a recession, this would be politically and (perhaps) economically difficult.

Tax cuts, another occasion, are already burned. Last December cuts led to what economists called the "sugar high," which is essentially a consequence of consumption spending in an already growing economy. With a $ 2.3 trillion budget and yet again high national debt, another round of tax cuts would be difficult and could (depending on its beneficiaries) flood liquid markets with unnecessary capital anyway is the main issue facing policymakers. When recession hits, the government may not have many resources to buy, rent, or lend when we need it most.

(This article has been corrected.)


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