Question

Some investors think that an Inverted Yield Curve is a sign that economic growth will soon stabilize or reverse. PLEASE EXPLAIN THEIR THOUGHTS (I am not asking if you agree with it. I just want to know what those investors are thinking.)

Answer 1

• An inverted yield curve means interest rates have flipped on U.S. Treasurys with short-term bonds paying more than long-term bonds.
• It’s generally regarded as a warning signs for the economy and the markets.
• A recession, if it comes at all, usually appears many months after a yield curve inversion.

investors may have a number of questions. What should they be thinking about in a low-rate environment in which the risk of near-term recession still appears small? If the yield curve returns to a positive slope, it’s likely that this will go hand in hand with investors becoming at least somewhat more positive about future economic growth and pushing back their forecasts of the starting date of the next downturn. If so, stocks and credit should outperform Treasury bonds handily,

An inverted yield curve is when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration. It's an abnormal situation that often signals an impending recession.

In a normal yield curve, the short-term bills yield less than the long-term bonds. Investors expect a lower return when their money is tied up for a shorter period. They require a higher yield to give them more return on a long-term investment.

When a yield curve inverts, it's because investors have little confidence in the near-term economy. They demand more yield for a short-term investment than for a long-term one. They perceive the near-term as riskier than the distant future. They would prefer to buy long-term bonds and tie up their money for years even though they receive lower yields. They would only do this if they think the economy is getting worse in the near-term.

So why does the yield curve invert?

As investors flock to long-term Treasury bonds, the yields on those bonds fall. They are in demand, so they don't need as high of a yield to attract investors. The demand for short-term Treasury bills falls. They need to pay a higher yield to attract investors.

 If investors believe a recession is imminent, they'll want a safe investment for two years. They may avoid any Treasurys with maturities of less than two years. That sends the demand for those bills down, sending their yields up, and inverting the curve.

Think of yield curves as similar to a crystal ball, although not one that necessarily guarantees a certain answer. Yield curves simply offer investors an educated insight into likely short-term interest rates and economic growth. Used properly, they can provide guidance, but they're not oracles.

It pays for most bond investors to maintain a steady, long-term approach based on specific objectives rather than technical matters like a shifting yield curve. But short-term investors can potentially profit from shifts in the yield curve by purchasing some small exchange-traded products, with relatively little trading volume such as the iPath US Treasury Flattener ETN (FLAT), or the iPath US Treasury Steepener ETN (STPP).

These two opposing investment types provide a good method of observing a yield curve while making a small profit if you are inclined to begin speculating in bonds.