By Grace Blakeley for New Statesman
On 22 March, the biggest news in the financial world was the inversion of the US yield curve. By the end of the day, Google searches for “recession” and “yield curve” had both spiked. It’s not hard to see why – the yield curve has inverted a year before every one of the past seven US recessions.
The yield curve charts the returns investors can expect from putting their money in government bonds with different maturity dates. The yield on a US Treasury bond is determined by the interest rate it offers and the price an investor pays for it, determined by supply and demand. Higher demand makes bonds more expensive, which pushes down their yields.
In general, investors seek a premium for holding bonds that mature over a longer period. Ten-year Treasury bonds should have a higher yield than three-month treasuries because investors expect to be compensated for the risk of lending the government money over a longer period of time. This means that the yield curve usually slopes upwards.
When the yield curve inverts, the returns on a longer-dated bond are the same as those on a shorter-dated bond – in this case, ten-year treasuries are yielding the same as three-month ones. In other words, investors aren’t demanding any more money for lending to the government over ten years than they are over three months.
The reason the yield curve is such a reliable recession indicator is that it reveals investors’ expectations. If they are worried about a future spike in inflation, traditionally associated with high growth, yields on longer-dated bonds will spike. Conversely, if investors aren’t demanding a premium for holding longer-dated bonds it means they don’t anticipate higher inflation, which means they aren’t expecting strong future growth.
The flight into longer-dated bonds – which are considered among the safest assets in the financial system – is also a flight to safety. If investors are uncertain about returns in other areas of their portfolios – such as equities or corporate bonds – they are likely to invest more in treasuries, which at least ensures they will not lose money.Read More
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