Question

You wrote, "However, when the economists and market participants expect a recession, the yields curve invert as well, which means that the higher duration bond yields are lower than, the lower duration bond yields." I wonder if you could explain and elaborate on the topic more. Why an inverted yield curve signals a recession? Provide examples to illustrate your points.

Answer 1

An inverted yield curve implies that the long-term yield is lesser than the short-term yield. In a normal yield Curve, the investors expect higher yield in the long-term than in the short term. This is because they are investing their money for a longer period of time and hence they are taking higher risk for which they required to be compensated. However when the yield curve inverts, it implies that investors have very little confidence in the future of the economy. They also perceive the short-term future as equally risky as the long-term.

For example in a healthy economy, the yield on a 20 year bond maybe three points higher than the yield on a 2 month bond. However when investors start believing that there are recessionary trends, the yield inverts and the yield on the two months bond will be higher than that on a 20 year bond. Investors will avoid the 2 month bond and will prefer the 20 year bond even though it is offering a lower yield.