Home / Business / Recession Clock: What is an & # 39; Inverted Return Curve & # 39; and why does it matter?

Recession Clock: What is an & # 39; Inverted Return Curve & # 39; and why does it matter?

Stock markets tanked Wednesday after the bond market sounded a high warning that the US economy might be heading towards a recession.

Investors are led by a scenario called "inverted yield curve", which occurs when interest rates on short-term bonds are higher than interest rates paid on long-term bonds. What this means is that people are so worried about the near future that they are being collected in safer long-term investments.

In a healthy economy, bonds typically require more to be paid – or a higher "return" – on longer bonds than for short-term bonds. That's because long-term bonds require people to lock their money over a larger period of time – and investors want to be compensated for that risk. However, bonds that require investors to make shorter commitments, say for three months, do not need as much quotation and usually pay less.

Just think of the deposits in your bank account, which in many ways is a loan to the bank. You can withdraw this money at any time so that the bank does not pay you a high interest rate. By comparison, if you lock your money in the bank for a year or longer, you get higher rates. The bond market works in a similar way: The longer you lend your money, the higher your return.

For US government securities – known as government bonds – that relationship has now turned upside down. On Wednesday morning, the yield on the 10-year Treasury fell temporarily below the yield on the two-year Treasury for the first time since 2007. (It recovered slightly.)

The following diagram shows the difference in yields between two-year government bonds and government bonds of different duration. Longer-term bonds should have higher returns, but as you can see, they have been dipped below for several long-term bonds.

Other parts of the yield curve have been inverted for a few months. For example, three months Treasurys has given more than 10-year Treasurys since the end of May. The gap became more dramatic Wednesday, with three-month Treasurys paying almost 0.4 percentage points more than 10-year Treasurys as of this afternoon, greater than the 0.1 percent difference at the end of May.

The more pronounced inversion is a sign that people are more worried about the fallout of the US-China trade war and worried about signs that economic growth may be slowing around the world.

So why do investors care?

The yield curve has inverted before every US recession since 1955, although it sometimes happens months or years before the recession begins. Because of this coupling, significant and long-term inversions of the yield curve are largely regarded as a strong predictor of a downturn.

Two researchers from the Federal Reserve Bank of San Francisco summarized it in a letter they published last year. "Predicting future economic development is a tricky business, but [yield curve] has a strikingly accurate record for predicting recessions," they wrote. "Periods with an inverted yield curve are followed reliably by economic downturns and almost always by a recession."

The fact that people are willing to take so little money for their long-term bonds suggests that they are not too worried about inflation, says Brian Rehling, co-head of the Wells Fargo Investment Institute global interest rate strategy. If they are not too worried about inflation, it also indicates that they expect the economy to grow more slowly in the future, he says. Inflation usually rises when the economy is hot.

"In essence, investors say, 'We are worried about financial weakness,'" Rehling said. says Rehling.

Fed officials lowered the reference rate by 0.25 percentage points last month, the first rate cut since December 2008. Investors now expect the Fed to cut interest rates by another 0.25 percentage points during its next meeting in September.

There is reason to hope that the economy will not go into a recession. The labor market is strong, and most people who want jobs can get one. Consumers still open their wallets, which boosts economic growth.

Even if the change in the yield curve is followed due to a recession, the slowdown cannot happen immediately. A review of previous downturns shows that the return Gene has usually inverted between six months and 18 months before the recession.

Andrew Van Dam contributed to this report.

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