Inverted Yield Curve Explained in 5 Minutes
This week the Yield Curve for US Treasuries inverted. You have probably seen all the news articles talking about this one financial metric. I am going to explain what this means and how it will affect your money. WATCH NOW
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Sources:
US Federal Reserve:
https://fred.stlouisfed.org/series/T10Y2Y
US Treasury:
CNBC:
VIDEO SUMMARY
What is the yield curve anyway? The yield curve is the rates of return you can expect to receive when you purchase a US Treasury Bond. If you go to the website of the US Department of the Treasury, they post the rates every day. Here are the rates from Friday, April 1, 2022. You can see the different durations of all the bonds, and the rates for each one.
What you need to realize, is that this one metric effects everything else in the financial world. The US Treasury is considered the least risky investment you can get. It is the financial backbone of the global economy. So, if something happens to the yield curve, it trickles down to everything else in Finance.
To understand how wild these numbers look right now, you need to know what the numbers are supposed to look like. Here are the average yield curve rates for 2021. A normal yield curve shows rising rates for greater durations of bonds, which is what we see here. This makes sense, because the longer you hold an investment the riskier it becomes. The higher the risk, the higher the return. If you were to hold a two-year treasury bond, you would expect to see it trading with lower yields than a ten-year bond, which is what we see here. If we graph these values, we see a beautiful yield curve with rising rates over time. This is what the yield curve should look like.
Here is the inverted yield curve from Friday. An inverted yield curve is when shorter bonds are selling for higher yields than longer bonds. We see that the two year bond yields more than the ten year bond. This should not happen and is a sign that something strange is going on in the market.
Here is another way to look at it. This is a chart showing the difference in yields between the two year and ten year bonds from 1980 to today. You can see that the line is normally above zero, because normally the ten year bond is trading for more than the two year bond. But sometimes, the line dips below zero. This is when the yield curve is inverted. The grey bars on this chart stand for recessions. So you can see that a recession typically happens about twelve months after the yield curve inverts.
WARNING: No financial metric is a guarantee of the future. It can always turn out to be a false alarm. But historically, this metric has been a good predictor of financial stress on the system, because an inverted yield curve is not normal.
How could this happen? Let us talk about the behaviors that is going on. Imagine a business executive with a large financial portfolio. Now, imagine a country like Russia is threatening the world with nuclear war. This person is holding a portfolio of 50% stocks and 50% bonds. This person says to himself, “I want to make my portfolio a little less risky, in case the stock market drops in the future.” In this case, the person might change the portfolio to 1/3 stocks and 2/3 bonds. For this situation, they would probably look to purchase five to ten-year bonds. Now if everyone tried to do this at the same time, supply and demand would push the price for these bonds higher. When you buy a bond, you pay one price at the beginning, and you receive set payments every period over the life of the bond. Those payments are not going to change. So, if you pay more money up front, that means overall you are making less money. More demand equals higher prices. Higher bond prices mean lower yields. In this situation, the five and ten-year bond yields would decrease, and the two-year bond would remain the same, causing an inversion.
In summary, if the yield curve is inverted, that means there is unusual market forces going on. Everyone is trying to purchase the safest asset class they can. This means, people are likely leaving the stock market, which could drive down stock prices over time.
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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.