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Why Inverted Yield Curve Is A Sign Of Recession

In recent weeks, we have repeatedly been hearing and reading (and maybe even experiencing) about how the economy is facing rough weather.

Moreover, this troublesome phenomenon is prevalent both across the global and local economy.

Whatever may be the reasons — US-China trade war, US-Iran tensions, Brexit, India's NBFC crisis and more — the fact remains that the economic situation worldwide is rather stressful.

And, the latest news is that the US Bond Yield curve has inverted:

Going by historical trends, this indicates further trouble for the economy... in one word, the dreaded 'recession'.

What is this 'inverted yield curve' and why is it considered as a sign of an impending recession?

Well, contrary to the high-sounding economic jargon, the answer is extremely simple and straightforward.

All it requires is to be explained in simple and straightforward language.

So here's the very-easy-to-understand explanation to the 'mysterious' inverted yield curve and why it could be a bad omen for the economy.   

First a few basic facts:
a. Bond prices and yields have an inverse relationship. When bonds prices fall, yields rise. When bond prices rise, yields fall.

b. Longer the maturity date of the bond, more is the rise/fall in the yields.

c. In a normal scenario, yields on short-term bonds are lower than the long-term bonds.

This is all plain school-level mathematics. Even your kid will understand this concept. For a detailed explanation on this, you can read my blog You Can Lose Money Even In The Govt. Securities.

Image by Alexas_Fotos from Pixabay

Now coming to what is happening in the US and Europe:

Of late, the bond prices have gone up. So the yields have fallen.

And, the effect is more pronounced in the long-term bonds. So much so that the yields on long-term bonds are now lower than the short-term bonds. Hence the term ‘inverted yield curve’ i.e. contrary to the normal scenario, long-term money is cheaper than short-term money.

Okay, so why have the bond prices jumped up?

Well, the logic is that the investors are not confident about the economic growth going forward. So they have become risk-averse. Consequently, they are switching their investment from stocks / corporate bonds to the US Treasury Bonds; which are considered as having the highest safety. This rush for safety has increased the demand for Treasury Bonds and hence led to an increase in the bond prices.

Normally, when there is some risk aversion, the gap between yields on short-term and long-term bonds reduce; but the long term yields remain higher. Going below short-term yields indicates extreme risk aversion.

Over the last 50 odd years, there has been a recession every time (except once) when the yield curve has inverted. Therefore, nowadays the inverted yield curve is taken as one of the signs of an impending recession.

Given the complexities of the world economy, the recession may or may not actually occur. But the economists are of the opinion that the likelihood is high.

And since the world is interconnected, recession in the US, Europe will have its impact across the world including India. Foreign investment in India will come down, leading to some correction in stocks, debt and currency markets.

As an investor, we should be well aware that booms and busts are part and parcel of investing. Therefore, instead of panic selling, we should remain invested and wait for the storm of 'inverted yield curve' to blow over.

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