Last week, one of the biggest stories in the market was about the yield curve and its inversion. The news of the inversion on the UK yields, followed by the inversion of the US yields was partly responsible for the increased volatility in the world’s stock markets.
In this report, We will explain what a yield curve is and why investors are worried about it.
What are Government Bonds?
The best way to start explaining what a yield curve is is to look at the bond market. The government is always in a constant need to raise money! It uses this money to fund development and pay salaries.
The easiest and most affordable method of raising funds is to issue government bonds. These bonds are usually short and longer-term bonds.
In a normal period, a longer-term government bond will have a higher yield. This is because most people are not interested in holding a bond for 30 years. The longer period is usually so difficult to predict. Therefore, longer-term bonds are usually better-yielders than the short-term ones.
A yield curve is said to invert when the yield on the short-term bonds is better than the long-term bonds. When it happens, investors tend to be expecting that there will be a short-term risk to the economy.
As such, they exit stocks and rush to the safety offered by the short-term government bonds. As they rush into these bonds, their yields decrease, or else, their price increase.
While there are many types of yield curves, the most commonly used one is the 10-year and the 2-year. The chart below shows the spread between the 10-year and the 2-year bonds. As you can see, the spread moved to below 0% last week.
Why Investors Care?
The only reason why investors care about the inversion of the yield curve is that it is one of the best predictor of recessions. As shown in the chart below, the yield curve inversion has predicted the past few recessions. In most years, the US has gone into a recession a year after the yield curve has inverted.
In this chart, the recessions are shown by the dark vertical lines.
What Causes Yield Curve Inversions?
There is no singular cause of the inversion of the yield curve. In fact, when they invert, it is usually because of a combination of many factors. For example, part of the reason why the yield curve inverted before the 2008 recession was that there were risks of household mortgage defaults.
In early 2000s, instead, the inversion was partly caused by the bursting of the dot com bubble.
The inversion this time has been caused by a number of factors. First, Donald Trump has upended the global order by initiating trade wars with countries like China. These wars have seen him increase tariffs levied against the country. More tariffs are expected to go into effect on September this year (the companies to watch).
Second, there are other smaller trade wars. For example, Japan and South Korea are engaged in a trade conflict.
Third, Brexit is a major cause of concern as investors fear about the impacts of a no-deal Brexit. The European economy has been easing, with countries like Germany expected to go into a recession this year.
How Should Investors React?
First, investors should be calm and realize that not all yield curve inversions have led to a recession. Also, it is very difficult to predict when a recession will happen.
Second, investors need to be proactive about risk management. This means that they should always use a sensible leverage and they should always protect their trades.
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Other external resources to understand Yield Curve inversion
Inverted Yield Curve – Investopedia
The yield curve inversion panic – Vox.com