Question

1. why does an inversion of the yield curve signals an imminent recession. Explain the mechanism at work.

Answer 1

Inversion of the yield curve will be signalling an imminent and impending recession because it will mean that the long term bond is trading below the short term bond yields and it will mean that investors are expecting slowness in the growth of economy in the long run and there would be a lack of demand and lack of inflation in the economy so there would be an environment of lower growth which will be coupled with lower rate of return in the economy so market participants are expecting lower rate of return for long term bonds and hence, They are betting upon the short term bonds and providing them with a premium because they are trying to reduce the risk associated with the investment in the long term bonds as they are highly sceptical about the performance of the economy on the downside and it is being represented through lower bond yield on long term bonds and hence it can be said that inversion of the yield curve is a signal of an impending recession in the economy.