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What is yield curve inversion? Investment Explained


In this series, we explain the jargon and explain a common investment term or topic. This is the yield curve inversion.

One sip

Real. It’s a bit complicated, but bear with me, as it’s an important and widely watched indicator, based on government bond yields. First, some basics. The return on an investment is the return to the investor from interest payments. Bonds, which are IOUs that can be bought and sold, typically pay a fixed interest rate or ‘coupon’.

This means that the yield depends on the price of the bond. If you buy a bond with a face value of 100p and a coupon of 10% for 90p, the yield is about 11%.

But if you buy the bond in 110p, the yield is just over 9%. Price and yield are inversely related: if a bond’s price falls, its yield increases.

Curve Shadows: Over the past half-century in the US, yield-curve inversions have been a reliable signal of a bleak or even recessionary economy.

Curve Shadows: Over the past half-century in the US, yield-curve inversions have been a reliable signal of a bleak or even recessionary economy.

Curve Shadows: Over the past half-century in the US, yield-curve inversions have been a reliable signal of a bleak or even recessionary economy.

Where does the curve go?

The yield curve is just a line on a chart that shows the yield on bonds versus the time it takes them to run to maturity.

Yields on shorter-term bonds are typically lower than those on longer-term bonds. This is because investors expect higher returns when locking up their money for a decade or more, during which time its value will be eroded by inflation.

Under normal circumstances, if the yields on three-month, two-year, and 10-year bonds were plotted, the curve would slope upward. But if pessimism focuses on short-term trends in the economy, yields on longer-term bonds can fall close to those on shorter-term bonds. This is called the inversion in the curve.

What does it indicate?

Over the past half-century in the US, yield-curve inversions have been a reliable signal of a bleak or even recessionary economy. This is why the indicator is such a big deal on Wall Street – and even more so this summer. Yields on 2-year and 10-year Treasury bills or bonds are the most scrutinized, which is why New York traders often talk about ’10-2 maturities’. .

So what is happening in America?

Since the beginning of July, the 10-2 yield curve inversion has been at its deepest in more than 20 years, seen by many as a signal of a recession, although inflation has cooled slightly. Others disagree, arguing that the yield curve inversion no longer acts as a crystal ball.

They say the only consequence of this reversal is that the Federal Reserve will be forced to raise interest rates faster than planned. This is confusing to observers because technically the US is in a recession. The economy has shrunk slightly for two consecutive quarters.

But banks are doing well, people are spending and 528,000 jobs were created in July, suggesting a recession is not necessarily a foregone conclusion.

Should investors be concerned?

America is the largest economy in the world. What happens there matters and will be closely watched in the UK. You could even say that the $23m (£19m) US bond market serves as a gauge of global economic health. For example, this week, the news that US inflation fell in July was enough to ensure that the FTSE 100 rose.

Some analysts focus on cases of yield-curve inversions in government bonds or the ‘gold-plated’ market, trying to discern the length and depth of recessions. But the index does not have what one commentator called a ‘mystery’ for UK policy.

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