This market concept is used when the US02Y or US03Y operate at higher levels than the US10Y, this behavior usually anticipates recessions, but why does this happen?
The inversion of the yield curve distorts the expected functionality of the financial system.
Under "normal" conditions, raising funds in the short term for investment in longer terms is used to provide positive arbitrage between interest rates on liabilities (paid) and assets (received), a strategy subject to the limits of the rollover capacity of the liabilities and raising new funds.
The availability of assets with higher premiums and liquidity, US02Y and US03Y, makes it less attractive to offer funds for longer terms < US10Y, and more expensive to raise funds for those who demand funds for shorter terms.
So the interest curve is considered a kind of thermometer of what lies ahead in an economy, and it is the graphic representation of how much investors are charging to lend money in different maturities, and once it is inverted, it means that it is more expensive to borrow in the short term than in the long term – an unusual thing, because more distant payment dates mean greater risks for the borrower.
In the US economy, a widely documented fact is that yield curve inversion (i.e., when there is a negative differential between long-term versus short-term bond yields) is a good leading indicator of periods of economic contraction. four to six quarters ahead.
According to data available on the Federal Reserve website, yield curve inversion has preceded every US recession since 1950, with the exception of a false signal in 1967.
There is also evidence that indicators of this nature are important predictors of periods of economic contraction in other countries.
But are there any silver linings to this unusual reversal scenario? Yes, in these moments of greater uncertainty we have an interesting opportunity to buy good companies at low prices.
This is because after the monetary tightening cycle, the economy usually weakens, during this period risk assets suffer, considering that their future projections will suffer due to the scenario, so many of the market participants seek security in bonds, others seek to anticipate the recovery considering that as soon as this CORRECTIVE cycle ends, a new UPWARD CYCLE tends to maintain perennial companies and give birth to many new companies that arise in the face of challenging scenarios.
Comment
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clear signs of recession
This drop in oil pricing is directly linked to the market's anticipation of the economic slowdown.
@jackofalltrades3224 It's actually just a chart with the ticker US10Y - US02Y, but instead of looking at bars or lines, go to chart types and select baseline, the chart will probably look like what you're seeing in this idea.
zerrith
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I have one comment about a statement made.
companies don't go bankrupt (or at least the big ones) due to the government printing money to save the "too big to fail" banks and companies.
we have been facing stagflation for years, the numbers are just hidden by the FED. food prices have always been going up and never seem to come down and real GDP numbers have been in the negative.
technology innovation has been stagnant too. we have not really made some new crazy invention or idea that can help the poor financially.
the fed have printed us to death, that and with the COVID lockdowns, we are screwed.
Keynesian economics has failed.
leandrosander_
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@zerrith, This is an interesting reasoning of yours, thanks for sharing it here!
davidbrother
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Interesting chart. Would it be fair to say that inversion means higher inflation expectations in the 'short' run, than the long one? Or do we come to a point in the duration curve where yields means more 'expectations for growth' than inflation?