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Yield curve inversion

Image source: Master1305 - Shutterstock

What's going on?

There was much consternation on Tuesday after the US “yield curve” inverted: 3-year US bonds are now paying more than 5-year ones. For some, that’s a signal of an impending (gulp) recession (tweet this)…

What does this mean?

When investors buy a government’s bonds, they’re loaning it money with the expectation that they’ll be repaid. Different bonds have different payback dates, and yields (the returns on offer) are typically higher for longer-term bonds than for shorter-term ones, to compensate for the extra risk involved.

But now US 3-year bonds are paying better than 5-year ones: the curving trend of long-term bonds paying more than short-term ones is inverted. This means that investors think the leader of the free world is less likely to pay back a loan three years from now than it is in five years’ time. There are various reasons for this unusual state of affairs: most notably, investors may think that either interest rates or inflation will soon fall. Both of those factors are linked to an economic slowdown – which is why some view the inverted yield curve as a harbinger of recession.

Why should I care?

For markets: More to follow…

Investors don’t really care about this yield curve: they focus on the difference between 2-year and 10-year bond returns. The gap between those two is the smallest it’s been since 2007, but the relationship hasn’t yet inverted. That being said, every past inversion between 3- and 5-year bonds has, without exception, been followed by a 2-10 inversion…

For you personally: Don’t panic!

Some people are now sounding the alarm, pointing to the fact that a 2-10 inversion has preceded every US recession since the 1950s. But there’s no need to panic just yet. There’s historically been a lag time of about two years between a 3-5 inversion and a recession: so if one is coming, there should be plenty of time to get ready.

Originally posted as part of the Finimize daily email.

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