Does Yield Curve Inversion Slow Down The Economy?
Yield curves are graphical representations showing the relationship between long-term debt funds and their yields. An inverted yield curve occurs when the short-term bonds provide a higher return than long-term bonds. This is also referred to as yield curve inversion. Many experts consider inverted yield curves as a precursor to a financial slowdown.
Here’s a complete breakdown of yield curve inversion and how experts use it for their analysis. Read on!
What is Yield Curve Inversion?
An inverted yield graph represents long-term debt yielding fewer returns than short-term debt.
Yield Curve Inversion is unusual. A normal yield curve is an upward sloping curve indicating a lower return at a shorter time frame with the yield increasing as the time horizon increases.
On the other hand, an inverted yield curve is a downward sloping curve showing higher returns in the short term and vice versa. It reflects bond investors’ expectations for a decline in long-term interest rates, which is typically a sign of an impending recession.
What does an Inverted Yield Curve Indicate?
Various experts around the world use an inverted yield curve to foresee any economic downturns. The curve precedes major recessionary periods, most notably the 2008 financial crisis. The yield curves become inverted when there is a huge increase in demand for long-term government debt securities like 10-year Treasury bonds, etc.
An increase in the demand for long-term debt-oriented assets increases their prices. This drags the yield of long-term debts downwards as price and yield share an inverse relationship. Any change in the shape of the yield curve is closely watched by investors. Any sign of inverted curves leads to panic buying debt securities, undermining confidence in the economy and leading to a slowdown.
Also Read: What is Risk Averse And How To Measure Risk Averse?
A brief history of Yield Curve Inversion
Many policymakers and investors consider inverted yield curves as a harbinger of a slow economy as they have preceded about seven US recessions. However, the time period between an inverted curve and recessionary period setting in is not uniform.
During the 1973 recession, an inverted yield curve showed up 6 months before the recession period. On the other hand, in the case of the 2008 financial crisis, the inversion of the yield curve started happening 2 years before the slowdown.
Although a recession or slowdown follows an inverted yield curve, investors should not consider this as an exit signal. This is because the price of many debt-oriented assets tends to rise even after the yield curve becomes inverted. Investors can wait and analyse the markets before making an exit strategy. This may not be an efficient tool for timing the markets.
As financial slowdown does not immediately follow yield curve inversion, investors are advised to reshuffle their portfolios and take corrective measures after receiving the first warning signs.
Why does the Yield Curve Become Inverted?
The demand for long-term debt securities plays an important role in making the yield curve inverted. The debt instruments, especially short-term bonds, are highly sensitive to government policies as well as changing interest rates.
On the other hand, long-term instruments are more reactive to the inflation outlook. The higher the inflation outlook, the higher will be the yield, as investors would want returns that can offset the inflation rates. When the central bank raises the interest rates, bond yields also increase.
Therefore, when the inflation outlook is stable, individuals tend to flock toward long-term debt securities. As demand increases, so do the prices of these debt instruments and which influences the drop in their yield.
Similarly, when the economy enters the recession phase, investors tend to move to safer assets like long-term treasury bonds. The stock markets, commodities and real estate sector take a beating, and there is mass migration towards safer assets. Again, this leads to an increase in demand for the securities; the yields start to fall, thereby making the yield curve inverted.
How does Inverted Yield Curve Affect Investments?
The inverted yield curve has a definite impact on various investment categories. Here are some of the ways it affects various types of investments:
- The fixed income investors who put their money in long-term debt securities are severely affected. They tend to lose the risk premium associated with long-term investments.
- With an inverted yield curve, the risk premium vanishes, and short-term investments provide better returns. As the spread between government and corporate bonds goes to historical lows, investors tend to go for low-risk instruments. This brings yields of government bonds on par with junk bonds, corporate bonds, etc. Hence, investors choose to go for lower-risk alternatives when the return is similar.
- The inversion of yield curves also severely affects equity investors. Financial institutions that borrow at short-term rates and lend at long-term rates take a hit on their profit margins. Moreover, hedge fund owners also have to take higher risks to attain their desired level of returns.
However, the inverted curve does not only have negative effects; it also has some positive influences on some sectors of the economy. The stocks of consumer staples, oil and some pharmaceutical companies tend to rise as a result of an inverted curve. These stocks are considered defensive stocks and are least affected during times of financial distress.
Also Read: How To Calculate Your Investment Returns With Mutual Fund Returns Calculator
Final Word
The yield curve inversion is an important component of the economic cycle. The inverted yield curves have made rare appearances after the 1990s, with the most recent appearance being before the 2008 financial crisis. These herald a change in market functioning. However, in today’s globalised and volatile world, one indicator cannot be considered as reliable for the onset of inflation.
FAQs on Yield Curve Inversion
Ans: The inversion curve of bond yields leads to heavy selling in the stock markets. Investors consider this as a sign of an impending slowdown in the economy, and they flock towards safer assets like gold or government securities.
Ans: One must follow the two fundamental rules of investing – diversification and alignment of financial goals. Even during times of yield curve inversion, you must stick to your investment objectives. Downturns are not perpetual, and markets will bounce back; hence unnecessary risk aversion can lead to below-par returns.
You should keep on diversifying your portfolio as it acts as shock resistant and protects your portfolio from unwanted risks. There must be adjustments to suit your objective.
Ans: The inverted curve negatively impacts consumers who have taken a loan under the floating exchange rate. As interest rates are affected by short-term rates, borrowers tend to pay more to repay their debt.
Ans: The last inverted yield curve happened in August 2019. There were fears of recession after that, and it negatively affected stock markets.
Ans: A healthy or normal yield curve shows short-term debt instruments offering a lower yield than long-term debt securities. Inverted yield curves are unusual and happen rarely.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
