A yield curve is a line that is obtained by plotting term to maturity on the x-axis and the yield on the bonds having equal credit quality on the y-axis. The slope of the yield curve gives an idea of future interest rate changes and economic activity. Thus, a yield curve represents the different interest rates that are paid to people who own bonds by each of the US treasuries. However, this bond yield curve becomes inverted at times. For instance, if a short-term yield curve pays higher yields/more interest rate than a long-term yield, there happens a bond yield curve inversion.
Types of Yield Curves
There are three main types of yield curve:
- Normal Yield Curve shows yields on longer-term bonds which may continue to rise, responding to periods of economic expansion. The most common type yield curve, it starts with low yields for short-term security bonds and then increases for bond with long-term maturity, sloping upwards. For example, a two-year bond offers a yield of 1 per cent, a five-year bond offers a yield of 1.8 per cent, a 10-year bond offers a yield of 2.5 per cent, etc. If we connect these points, we get a normal yield curve.
- Inverted Yield Curve slops downward and indicates that short-term interest rates exceed long-term interest rates. Such curves correspond to periods of economic recession where investors expect yields on long-term bonds to become even lower in the days to come.
- Flat Yield Curve is defined by similar yields across all maturities, except a few intermediate maturities with slightly higher yields, which generally happens for the mid-term maturities. In times of high uncertainty, similar yields across all maturities are in demand by investors.
A bond is an agreement where the borrower (government or organisation) assures the investor to pay back the borrowed amount plus the interest for a given period. Generally, the long-term yield is more than the short-term yield.
Causes of Yield Curve Inversion
The present inversion of the yield curve has surfaced especially due to the current situation in the US and its possible effects on the global economy. Inversion of the yield curve takes place when there is an increase in demand for long-term bonds. As the demand for long-term bonds increases, the price of the bonds also increases. Yield has an inverse relationship with respect to bond prices, as prices increase, the yield falls. So, when there is speculation of risk in the short run, investors prefer long-run bonds. The price of short-term bonds falls and the price of long-term bonds rises resulting in an inverted yield curve.
Most of the recessions in the past have been preceded by an inverted yield curve. There have been seven recessions in the US since 1960 and all of them were preceded by a common pattern—the inverted yield curve. The financial crisis of 2008 was also preceded by an inverted yield curve. At present, the entire world is concerned about the inverted yield curve in the US. Though some of them mentioned that the yield curve is not inverted yet, the gap between the long-term and short-term bond yields has been declining rapidly.
According to economists, every yield inversion need not result in recession. There is always a time gap—a few months or even years—between the inversion of bond yield and recession. An inverted yield curve is not the cause of the recession. It is one of the indicators of recession. It is a representation of the expectations of people about the future and economy of the country. An inverted yield curve could also lead to an economic slowdown. The impact of a recession is much more than economic slowdowns.
Impact of the Yield Curve Inversion
There are arguments among economists both for and against the recession that can take place due to the yield inversion. Some experts warn that there could be impending recession that will be going to take place and that people should be aware of their investments so that they can avert the risk; while others feel that, there might not be a recession but an economic slowdown with the already existing high inflation and unemployment. The yield curve is an important factor to assess the situation of the economy but is not the cause or the only indicator of recession.
© Spectrum Books Pvt Ltd.