August 20, 2019

Don't Misread the Inverted Yield Curve

“At the end of last week, the three-month Treasury bills’ yield rose above the yield for 10-year Treasuries for the first time since 2007, prompting warnings that the U.S. is headed for recession later this year or in early 2020. That’s because, historically, such “curve inversions” have tended to precede major economic slowdowns by about a year. Yet, for reasons that relate both to the current determinants of the yield curve and the underlying state of the economy, the latest curve inversion could prove to be an exception to the rule — unless a misreading creates a detrimental self-fulfilling prophecy.

Yield-curve inversions are unusual because they involve lenders being willing to earn less interest income on money they commit, and therefore underpin both credit and liquidity risk, for longer. This typically happens when investors expect that yields on shorter-term maturities will fall substantially as the Federal Reserve cuts rates, also potentially dragging down longer-term bonds. This is most likely to occur if the economy is slowing sharply and faces a meaningful risk of recession.”

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