If you closely follow financial headlines, you might have heard the buzz or talk about the inversion of the five-year and 30-year treasury bonds. But why does it seem so scary, and what does it all mean?
Since March this year, there have been talks about the treasury yields inverting for the first time since 2006, which poses the risk of a possible recession.
An inverted yield curve is a sign that short-term investments are paying more than long-term investments in US treasury bonds. This may be seen as a sign of the economy going down.
This year, the yield for the 5-year treasury bond rose to 2.56%. On the other hand, the 30-year treasury note dropped to 2.55%. Financiers and investors are closely watching these circumstances as an inversion like this preceded the Global Financial Crisis of 2007-2008.
A yield curve is a line that tracks the plots of yield or interest rates of bonds with equal credit quality on differing maturity dates. The slope plotted can give financiers, economists, politicians, and investors an idea about future interest rate behavior and economic activity.
People are closely watching three classes of yield curves—the normal yield curve, the flat yield curve, and our area of concern, the inverted yield curve.
The normal slope indicates that long-term bonds, like the 30-year treasury bond, will continue to rise in value during periods of positive economic expansion. Bonds with longer maturities will continue to grow in value.
The flat curve indicates a similar yield value across all bond maturities, whether the newer 5-year or the 30-year bond. This phenomenon usually happens due to uncertain economic situations. It can happen after high economic growth, which can precede inflation. It can also occur when central banks increase interest rates.
Inverted yield curves downward, indicating the increase in short-term bond interest rates over the long-term rates. Inverted yields are a rare occurrence. A negative yield curve usually indicates a coming recession and signals many market participants.
This inversion means that the short-term US treasury pays interest rates higher than other long-term treasuries. Campbell Harvey introduced this term as a recession indicator in 1986.
Although an inverted yield curve is a reliable indicator of a prospective recession, it does not cause it. It reflects investors’ expectations that long-term yields—like the 30-year treasuries—will decline. This is the usual pattern during recessions.
Investors watch the market closely, and as circumstances like Russia’s war with Ukraine dictate the market, investors expect losses in stocks.
Stock investors choose to sell stocks and convert their money to bonds. This means higher demand for bonds while the yield pay plummets.
This phenomenon occurs because the meager returns of bonds are better than the likely losses investors may incur by holding stocks through a recession. This could be one reason for this trend in yield.
Although it is not causative, an inverted yield curve represents the loss of confidence in the financial future of a country’s economy.
If there is a premonition of economic instability around the corner due to instability in the market and governments, investors will turn to the safest tactic, usually government bonds.
Does this mean that we are witnessing a repeat of the 2008 financial crisis and expecting a big crash in the stock market? No, not necessarily. A recession or crash will depend on many factors.
The first factor is the duration of the inversion. A brief inversion may only indicate a slight anomaly and may not lead to recessions.
A downward curve can also mean that the Federal Reserve has put a benchmark on short-term bonds, and the central banks are also cutting rates since the economy is slowing.
Central banks’ lowering of interest rates has been key to fighting the Great Recession. Bond yields and interest rates were low throughout the recovery from the 2008 crisis and the expansion that followed it right after. According to market observers, although this may warrant caution, there is no need to panic.
In case there is a looming recession on the horizon, it will still take a long time for everyone to feel the effect. Some average it to 22 months following an inverted yield without any intervention.
An inverted curve is still a standing indicator, and its appearance doesn’t necessarily mean that a recession is coming.
Nevertheless, it doesn’t change the fact that the theory has held for the past six decades and preceded seven recessions.
Amidst this winning streak, keep in mind that inversions are not infallible indicators of recessions. Interventions following an inverted curve can prevent financial catastrophes.