What is an Inverted Yield Curve?

A few weeks ago we witnessed an inversion in the yield curve. What does that mean?

For starters, what is a yield curve?

The yield curve is a graphic representation of the expected return rates that the US government bonds will pay at different time horizons to its holders.

The interest rate, or the price of money, is a premium that investors expect to receive because they are willing to forego their assets for a period of time. The size of said prize, or rate, must reflect several aspects such as credit risk, currency, or length.

It is fair to asume that, if someone is willing to “lend” their money for a longer time span, the rate should be higher than for a shorter one, and this is commonly the case. Therefore, if one were to plot the expected returns of an instrument, such as the treasury bonds of the United States, the result would be an ascending line, or curve.

Usually experts pay attention to the differences that exist in different terms and draw conclusions based on the size of these differences.

The Inverted Yield Curve occurs when short-term instruments grant a higher interest rate than long-term ones, which is counterintuitive.

In addition, these types of anomalies have been witnessed, consistently, in anticipation to important adjustments in the markets and economic recessions.

During the last week of March, the rate of the 1-year treasury (2.45%) exceeded that of the 10-year bond (2.44%), generating anxiety among investors.

From 1954 to date, this singularity has occurred 10 times, anticipating 9 recessions within an average horizon of 18 months.

Let’s try to define what would cause these scenarios.

It must be remembered that interest rates are usually a tool of central banks to boost growth and / or control inflation. In the face of recessive periods, authorities usually reduce the price of money to encourage growth. As a recent example we can see the accommodative policy of the Fed in the wake of the 2008 crisis.

If investors anticipate deceleration along the way, they could assume that in the following years the authorities should take actions that encourage growth. This approach seems to bring us back to the question of what came first: the chicken or the egg, or end with a self-fulfilling prophecy.

This anomaly in rates reversed by the end of the month, but the investment community will surely continue to follow it closely.

One of the most dangerous phrases in finance is “this time is different”; however, it is worth mentioning some differences with what has happened historically. Current rates in historically low levels in absolute terms, controlled inflation, intricately linked global markets, regulators acting more proactively, among others.

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