Yield curve inversion: A layman’s guide

This past week was extremely volatile for global financial markets. Bond yields fell across all developed markets, and the US yield curve inverted briefly on Wednesday (14 August) for the first time since 2007. Historically, yield curve inversion portends a recession in the US and signifies a slowdown of economic growth. To properly understand the phenomenon, we start with a brief explanation of bonds. Bonds are how companies and/ or governments borrow money from investors – a bond is a contract which undertakes to pay an investor back, with interest, on a specific date in the future. The yield on a bond is commensurate to the risk you take in buying that bond. If you hold a bond for a short period you are likely to have more certainty that the company or government will be in “good health” at the end of the period, than if you hold the bond for a longer period, such as ten years.

Because companies and governments that sell bonds want to lock in long-term financing, these companies and/ or governments promise a higher yield to investors who, in turn, lend money over a long time. If, for example, you buy a bond in which a company or government promises to pay you back over 10 years, your yield should be higher than investors who only lend money for one year. Lending money over a long period is an indication that the investor has faith that a company/ government will still be in good ‘health’ 10 years hence. For example, looking at Treasury bonds or debt sold by the US federal government, investors are lending the US government money over three timeframes – 3-month, 2-year and 10-year. Yields on 10-year Treasury bonds should always be higher, because of the long period attached to these bonds – investors rightly expect to be compensated for the added risk they are taking by owning bonds with longer maturities.

However, over the past few months, yields have been higher on shorter-dated bonds (i.e. 2-year bonds). This means buying US Treasuries for only 3 months, for example, paid more than keeping them for a decade and this is where the so-called yield curve inversion comes in. On Wednesday, investors could, albeit briefly, make more money by buying 2-year Treasury bonds than by purchasing 10-year bonds. The phenomenon of being paid more (the yield) for a short-term loan than a long-term loan to the US government is known as the inverted yield curve i.e. upturned, upended and upside-down version from what is the generally accepted norm.

Markets react badly when this happens because when the yield curve has inverted, it indicates that investors have little confidence in the near-term economy and that recession fears are increasing.

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