What Is An Inverted Yield Curve And Why Is It Important?

What Is An Inverted Yield Curve And Why Is It Important?

By Yash

There are a lot of things for experts and investors in the economy of the nation to worry about at the present moment. Inflation is right now at the highest mark in nearly half a century. There is a full-fledged war going on in the continent of Europe. Also, the Federal Reserve is increasing the interest rates, and there is an increasing political deadlock in the nation. Now, there is news of the inverted yield curve. The latter is a line that measures the yield of several durations of bonds. In the usual times, the line should go upwards. This is because the yields go higher with longer periods of the bond. This shows that there is more risk of the unknown. In the shorter-duration bonds, the yield is less than for long-duration bonds. But in the previous month, one of the shorter-duration bonds had a higher yield than a long-duration bond. This means that there was an inverted yield curve.


The Importance of the Inverted Yield Curve


The inverted yield curves show the fluctuations in the upcoming path of the national economy. It often works as a warning symbol of an upcoming recession. But this is not always the case. It is also not a precise tool for getting the right timing. This is because the inverted yield curve can stay inverted for a long time before any recession. There are times when this can be wrong also. In the case mentioned in this article, it got back to its usual position within a day before going back to the inverted yield curve. But it is a fact that bond investors are scared by this curve. This is because the raging inflation is not looking to subside anytime soon. The inflation had been described by president Joe Biden and the chairman of the Federal Reserve as transitory. The main cause for the inverted yield curve was a speech in March where the chairman sounded more careful than he had been in the past. The speech happened after the first increase in the interest rates in nearly five years by the Federal Reserve. It increased the rates by a quarter of a percent in that month.


This signaled to the bond traders that the Federal Reserve would make a move in some months to increase the interest rates by half a percentage point. It looked like it was going to go against challenges in trying to create a soft landing for the national economy and avoid any full-blown recession. Jerome Powell said, "We will take the necessary steps to ensure a return to price stability. In particular, we will do so if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meeting. Frankly, there's good research by staff in the Federal Reserve system that really says to look at the yield curve's short – the first 18 months. That's really what has 100% of the explanatory power of the yield curve. It makes sense. Because if it's inverted, that means the Fed's going to cut, which means the economy is weak." Megan Greene, the chief global economist for the Kroll, said, "I think the bigger worry is that the Fed kills off this economy."


Normal Yield Curve or Inverted Yield Curve?


In the previous week, the financial markets were completely focused on the gap between the yield of the short-term and the long-term treasury bonds. This makes complete sense. This is because traders do not usually have a long-term horizon. But there are other entities that look to pay attention to the various other yields. This includes the very short and the long treasuries also. The inverted yield curve is not present on the very short treasury bonds. Some experts, including the Federal Reserve chairman, have given a more granular reading. They have placed their attention on the shortest portion of the curve. That portion of the curve has no inversion at present. The experts at a research firm studied several yield curves recently. They said that the inverted yield curve had been a reliable indicator of a recession.


But it had some caveats as well. They said that the measures given by the chairman could be cited as the Fed Slope. It does not matter which point of the slope the people want to focus on. A vital consideration is that the inverted yield curve means that there can be a recession in the national economy on the horizon. But it is unsure when that can happen. In the past, the financial markets and the national economy stayed positive for a long time after sighting an inverted yield curve. The experts said their research suggests a probability of a recession over the next year. But the chance of that happening is under fifteen percent.


On Monday, Jason Pride, the chief investment officer of private wealth and Michael Reynolds, vice president of investment strategy at Glenmede Trust, wrote. "The spread between 3mo and 10yr Treasuries has a modestly better track record, leading recessions by 17.3 months on average. However, the main risk to the outlook would be aggressively hawkish monetary policy, so the Fed should tread carefully along its tightening path. Over the last six economic cycles in the U.S., the 2yr-10yr spread inverted for the first time 18.6 months before the beginning of the next recession on average. The 2-year/10-year Treasury slope has inverted in advance of 7 of the past 8 recessions and has not sent a false signal. The 3-month/10-year Treasury slope has done even better, calling 8 out of the last recessions without a false signal. Meanwhile, the Fed Slope has also called out 8 of the past 8 recessions, but it sent one false signal in September 1998."


Has the Inverted Yield Curve Happened Because of the Pandemic?


The pandemic gave a big shock to nearly every economy around the globe. It led to the shortest yet sharpest recession on record in the nation. Several experts said that the inverted yield curve that happened nearly three years ago was proof of the accuracy of its prediction of the recession. But that recession had happened because of the highly unusual nature of the coronavirus pandemic. Nations around the planet had taken part in a synchronized shutdown of their economies. It is quite probable that there would not have been any recession if the pandemic had not happened. One of the main elements, when there is an inverted yield curve, is that it does not give a signal to sell to the people who invest in the financial markets. The rates in the financial markets were already increasing before the Federal Reserve started its measures in March. It removed the notion that the present conditions in the bond market have happened as a reaction to the Federal Reserve's actions.


John Mousseau, president, CEO, and director of fixed income at Cumberland Advisors said, "So, when compared to (the 1.9%), a 60-basis-point rise in rates seems more reasonable, particularly given that inflation has risen (though we also think we will see some retreat in inflation later in the year). We don't think this is as much the market front-running the Federal Reserve as it is a reversion to the mean after COVID." Glenmede's Pride and Reynolds said, "What should matter most for investors is the signal that the curve can give for markets. Over these last six (economic) cycles, the S&P 500 posted positive returns between inversion and the actual beginning of the recession in the U.S."




Many experts are questioning whether the inverted yield curve is a good indicator of any future recessions in the nation's economy. But they should keep in mind that the history of the economy is strewn with portfolios of investors that were devastated when they followed the predictions of experts who said that it was not the same this time. This has been seen recently when many investors in the financial markets picked up stocks in tech firms at high prices even though these firms did not hope to make a profit.