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Yield Curves & Inversions


Historically speaking, inversions have often been a predictor of negative economic consequences.


Jumpin' up, fallin' down
Don't misunderstand me
You don't think that I know your plan
What you tryin' to hand me?
--James Gang

If you're seeking to buy a bond, would you require a higher interest rate from a bond that matures in (a) three months or (b) 10 years? Most would demand a higher rate on the 10 yr bond to compensate for the increased risk of inflation eating away the value of the interest payment over the next decade. Strangely, however, there have been times when long term rates are lower than short term rates. This situation is known as 'inverted yield curve' and, historically, it's had significant market implications.

Effective market participants are aware of the meaning of an inverted yield curve and its historical market implications.

Curving the Yield

Most of what is known as the 'national debt' is funded through bonds sold by the US Department of the Treasury (here's a running tally of the size of the national debt). The Treasury sells bonds of various durations, ranging from bills maturing in less than a year to bonds maturing 10 years or more in the future. Folks buy the bonds for the interest payment, a.k.a. yield. The yield curve normally refers to the spectrum of interest rates offered by US Treasuries of different duration.

Normally, bond buyers demand higher yields on bonds with longer duration. This is because of the risk that inflation will eat away at the effective yield. If for example, a particular bond yielded 4% annually but inflation averaged 8% annually, then holders of this bond actually lose 4% annually in real terms.

So, under normal conditions the yield curve is usually upward sloping--higher yields correspond to longer durations. In the graph below, the 1/30/2004 and 1/31/2005 yield curves reflect this normal condition.

Every now and then, however, yields on the short end exceed yields on the long end. When this occurs, we say that the yield curve is inverted. In the graph below, the 1/30/2006 and 1/17/2007 yield curves reflect a situation of increasing inversion.

Note: If you want to get a dynamic look at the shape of the yield curve over the past decade, go here and click the 'animate' button.

Source: US Treasury

Explaining Inversion

So why would bond buyers accept a lower yield on longer duration bonds? The conventional reply is that market participants expect an economic slowdown. An economic slowdown would reduce the chances of inflation and might even spur deflation. Deflationary situations are usually good for bonds because interest rates fall (remember, when interest rates fall, bond prices go up). So, if market participants forecast a deflationary situation out in the future, they might rationally accept a lower yield on long term bonds.

The second explanation is much less 'mainstream' but worthy of consideration nonetheless. Economies that carry high amounts of debt, such as the present US economy, need low interest rates in order to function. Because of the high amounts of leverage present in the economic and financial system, even small increases in interest rates can escalate debt payments beyond the capacity of debtors to pay. Should this happen, economies and markets might lock up, causing recessions or worse. To the extent that foreign creditors perceive the severity of such a situation in the US, foreign central banks might intervene and 'buy the long end of the curve' in an effort to suppress interest rates in order to keep trade flowing (and perhaps to preserve risk taking). Evidence supporting such activity can be found in Treasury Dept data that indicates high levels of US asset buying by foreigners during the yield curve inversion of 2006-2007.

Consequences of Inversion

Why should you care whether the yield curve is inverted or not? Historically speaking, inversions have often been a predictor of negative economic consequences. For instance, the yield curve inverted prior to the big decline in stock prices in 2000. Over the past 50 years or so, inverted yield curves have been effective predictors of pending recessions.

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