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How do inverted yield curves affect the economy?

How do inverted yield curves affect the economy?

Treasuries rallied this week prompting some crucial parts of the US yield curve to flip. This has commonly been a strong indicator that the US economy has become bearish.

The two-year and five-year note curve inverted on January 27th marking the first time it has happened this year, and the ten-year curve also temporarily inverted yesterday for the first time in three months.

Growing concerns over how China’s coronavirus will affect the economy has pushed investors to turn to safe-haven assets.

The latest inverted yield curves have counterbalanced hopes that 2020 would bring an increase in economic growth and inflation, following the signing of the phase one China-US trade deal.

Investors closely monitor the gap separating ten-year and three-month yields. When ten-year yields drop lower than three-month bills, it has traditionally been a sign that the economy could fall into a recession soon.

What are Treasury Securities?

Treasury securities are considered a safe haven amongst investors as it is often considered a conservative investment option. These instruments have made a reputation over the years as a stronghold of safety when faced by the volatility and unpredictable nature of the financial markets.

Various guarantees come with Treasury securities and are often considered as one of the pillars of economic growth and sustainability. Treasury securities are sought after by independent and institutional investors.

Treasury securities can be broken down into three groups depending on their maturity periods. Investopedia.com outlines the three categories as follows:

  1. ‘T-Bills – These have the shortest range of maturities of all government bonds. Among bills auctioned on a regular schedule, there are five terms: 4 weeks, 8 weeks, 13 weeks, 26 weeks, and 52 weeks. Another bill, the cash management bill, isn’t auctioned on a regular schedule. It is issued in variable terms, usually of only a matter of days. These are the only type of treasury security found in both the capital and money markets, as three of the maturity terms fall under the 270-day dividing line between them. T-Bills are issued at a discount and mature at par value, with the difference between the purchase and sale prices constituting the interest paid on the bill.’
  2. ‘T-Notes – These notes represent the middle range of maturities in the treasury family, with maturity terms of 2, 3, 5, 7 and 10 years currently available. The Treasury auctions 2-year notes, 3-year notes, 5-year notes, and 7-year notes every month. The agency auctions 10-year notes at original issue in February, May, August, and November, and as reopenings in the other eight months. Treasury notes are issued at a $1,000 par value and mature at the same price. They pay interest semiannually.’
  3. ‘T-Bonds – Commonly referred to in the investment community as the “long bond”, T-Bonds are essentially identical to T-Notes except that they mature in 30 years. T-Bonds are also issued at and mature at a $1,000 par value and pay interest semiannually. Treasury bonds are auctioned monthly. Bonds are auctioned at original issue in February, May, August, and November, and then as reopenings in the other eight months.’

However, while an inverted yield curve is commonly linked to an imminent recession, uncertainty is rife with geopolitical tensions around the world, and other factors such as an end to the trade war between Washington and Beijing could push a potential recession further down the line.

Some economists believe that the allure of US bonds in Japan and Europe, the majority of which could have inverted yields, is blurring the reliability of the readings of the economic indicators.

Treasury yield curve explained…

The Treasury yield curve is a method of mapping all the yields of the Treasury maturities, which is debt put up for sale by the government, spanning from one-month bills all the way to 30-year bonds.

The Treasury yield curve usually has an arcing incline due to investors expecting higher compensation for investing in bonds with long maturities.

What is a steep and flat curve?

A steep curve occurs when yields with long maturities are notably higher than those will short maturities. For example, when a steep curve occurs a 30-year bond will bear a greater yield than a one-year note.

Therefore, a flat curve occurs when yields that are further down the line on the curve are almost on the same level as yields that are closer to the front. When this happens, a three-year bond, for example, may offer a slightly greater yield to that of a one-year bond.

What is a yield curve inversion?

Sometimes the yield curve can lose its incline slant. When this happens the shorter-dated bonds offer higher yields compared to longer-dated yields; this, in the investing community, is commonly known as a yield curve inversion.

Some analysts may pay attention to key areas of the yield curve, but any time a yield curve inversion occurs it’s often a sign that a bout of weak economic growth is approaching.   

Are inversions an economic indicator?   

Yield curve inversions are often precautionary warnings of an imminent economic recession.

When yield curve inversions occur consumers are often the ones to pay the highest price; borrowing costs increase and consumer spending plummets. When you have an economy, for example the US economy, which is heavily dependent on consumer spending to make up large portions of domestic economic growth and activity, bouts of inversion can have devastating effects. When economic activity decelerates and the GDP growth rate remains negative for two or more consecutive quarters, the economy falls into a recession and unemployment rates rise.

Why do yield curve inversions happen in the first place?

Short-dated Treasury securities are very responsive to monetary policy changes imposed by the central bank of a country, for example, the Bank of England.

Long-dated Treasury securities are highly sensitive to investor forecasts of inflation rates.

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