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  • Nick Burgess

What Exactly Is The Inverted Yield Curve?

If you're someone that loves to wake up, turn on Bloomberg and see what happened in the overnight Asian markets, you've likely run into the term "inverted yield curve." If you're a casual, Robinhood-type investor, then welcome to the dark side! It's time to discuss one of the most ominous terms in economics, and what it could mean for you (spoiler: alot). This is the world of the Inverted Yield Curve.


What Is An Inverted Yield Curve?

An inverted yield curve is a phenomenon in which the interest rates on short-term government bonds are higher than the interest rates on long-term government bonds. This is considered a rare event and is often seen as a sign of an impending recession. In this article, we will discuss what an inverted yield curve is, its causes, consequences, and what it means for the economy.

Understanding Yield Curves

First, let's understand what a yield curve is. The yield curve is a graphical representation of the relationship between interest rates and the length of time until a bond matures. Typically, the yield curve is upward-sloping, meaning that long-term bonds have higher interest rates than short-term bonds. This is because investors are assuming more risk in the long term, so they are paid greater yield in exchange for the risk trade-off.

a typical government bond yield curve showing that longer term bonds have a higher interest rate than shorter term bonds
A typical yield curve circa 2014 (via Investopedia)


The Bond Market Relationship

There's generally a pretty smooth relationship between the curve associated with shorter term bonds and longer term ones, but they do intrinsically have different interpretations.


According to Liz Young, SoFi's Head of Investment Strategy, a 2-year Treasury is much more closely associated to what investors think the Federal Reserve is going to do in the near-term. This is opposed to a 10-year Treasury, which is more closely associated with *checks notes* investor fear in the market.

But what does "fear" actually mean? Well, imagine that you're concerned your stock market position is going to fall over the next few years. Why would you want less money in the short-term? So you flood to Treasury bills and assume a little bit more risk in buying 10-year bonds for a bigger return. Now imagine that thousands, tens of thousands or hundreds of thousands of investors are doing the same thing. This buys the rate down further and further, reducing that yield on the bonds because the demand is now outstripping the supply. This sends the yield curve downwards, towards the depths of investor hell.


The Inverted Yield Curve

Now, let's talk about an inverted yield curve. Like I mentioned a minute ago, this is a sign that investors are less confident about the future and are therefore willing to accept a lower rate of return on their long-term investments. This can happen for a number of reasons, including concerns about inflation, a slowdown in economic growth, or a decrease in the demand for loans.

For the purposes of this conversation, let's chat about a yield curve inversion based on an economic slowdown, which seems to be what's happening to the U.S in 2023.


Economic growth can slow down for several reasons. For example, a decrease in consumer spending, a decrease in investment, or a decrease in government spending can all lead to a slowdown in economic growth. Additionally, external factors such as a decrease in the demand for goods and services from other countries can also contribute to a slowdown in economic growth. And that's what's happening here, right? 2023 is seeing the unholy trinity of these factors, along with some COVID-spurred habits that no one really saw coming. People are spending through their pandemic-era savings like Scarface in a pile of Colombia's finest, travel has exceeded 2019 levels and Patagonia-vest wearers are beginning to feel the weight of FAANG layoffs. The era of the spend slowdown is coming, and coming fast, leading to a dramatic slowdown of spend. Then, there's inflation.


Inflation's Effect on the Yield Curve

Inflation can also be a cause of an inverted yield curve. When inflation is high, the interest rates on loans increase to compensate for the decrease in the purchasing power of money. This can lead to an increase in the interest rates on short-term bonds and a decrease in the interest rates on long-term bonds, as investors are willing to accept a lower rate of return in exchange for the stability and security of a longer-term investment.

Inflation can happen for several reasons. For example, an increase in the cost of goods and services, an increase in the cost of labor, or an increase in the cost of raw materials can all lead to inflation. Additionally, an increase in the money supply can also contribute to inflation.


Yield Curves and Recessions

One of the most notable consequences of an inverted yield curve is the increased likelihood of a recession. An inverted yield curve has preceded every recession in the United States since 1950, and is therefore seen as a reliable indicator of an impending economic downturn.

As a quick reminder, a recession is technically defined as a period of economic contraction, characterized by a decline in gross domestic product (GDP), employment, and trade. During a recession, businesses may close, and consumers may cut back on spending, leading to a decrease in economic activity (remember the last section where we talked about this being the leading yield curve cause? It's like a fucked up economic hamster wheel).


It is worth noting that an inverted yield curve is not always a surefire indicator of a recession. Some experts argue that the yield curve can be inverted for other reasons, such as a change in monetary policy or a shift in global capital flows. For example, the Federal Reserve may decrease short-term interest rates to stimulate economic growth, leading to an inverted yield curve (obviously not what's happening this year with JPow on a spender bender).

Additionally, a shift in global capital flows can lead to changes in the demand for bonds, leading to changes in interest rates. Again, we are seeing all of this happening in real-time, like a whirlpool of high interest rates and layoffs. During the last 12 years, it's like we've been at a nice dinner with a group of people ordering the extra bottle of wine or the seafood tower, but now the bill is coming due and the game of credit card roulette is getting higher stakes.


The Positives(?) of an Inverted Yield Curve

It is also worth noting that an inverted yield curve is not always a negative event. Some experts argue that an inverted yield curve can actually be beneficial for the economy, as it can lead to lower interest rates and increased borrowing and spending. For example, lower interest rates can make it cheaper for consumers and businesses to borrow money, leading to increased spending and investment. If you're a millennial reading this sentence, this is really best case scenario for you as this could lead to lower mortgage rates and potentially lower home prices, allowing you to finally purchase that starter home at the ripe age of 41.

Conclusion

In conclusion, an inverted yield curve is a complex phenomenon that can have a significant impact on the economy. Understanding what an inverted yield curve is, its causes, and its consequences is essential for investors, economists, and policymakers to make informed decisions. It is important to note that an inverted yield curve is not always a sure sign of a recession and can also have positive effects on the economy. Therefore, it is essential to pay attention to the indicators and consult with experts in the field.

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