Everything You Need to Know About the Yield Curve – Introduction
The global economy is improving. In the United States, the economy is expected to rise by 4% in the second quarter. The unemployment rate has dropped to 3.8%, the lowest level in decades. Wages are improving, and inflation has been contained below 2%. Consumer confidence is rising, and more people believe that the economy is doing well. The same trend is being repeated in most developed countries of Europe, Australia, and New Zealand.
The growth is being experienced despite of the ongoing challenge on global trade. Recently, the world has moved towards a trade conflict that will probably be the biggest in history. Today, the US administration is compiling a list of more than $200 billion Chinese goods to place tariffs on. On Friday, he announced that he would place tariffs on European cars. All the countries have threatened to retaliate.
Other than trade, the biggest concern among traders is on the issue of the yield curve. If you watch or read financial news regularly, you have likely seen or read that the yield curve is inverting or flattening. In this article, I will explain what all this means and why it is dangerous.
Governments around the world are known as being the best lenders. This is because of their low probability of defaulting on their obligations. If they are unable to service their debts, they can easily increase taxes to raise more money. Governments raise money by offering bonds. In other words, government borrows money from investors which it uses to fund its projects.
The bonds issued by the government usually mature in certain periods. This period ranges from one year to 30 years. Some governments have issued bonds that are dated at longer timeframes.
The yields on the bonds usually range between the countries. The yields of a country that has more chances of a default usually have higher yields. This yield is usually high because of the risks that they present to investors. In additional, longer-dated bonds usually have more yields than short-term yields. The logic behind this is simple. We can tell whether a country will default in the next two years but we cannot tell how it will look like in the next thirty years. Will another world war break out?
Therefore, whenever you hear about the yield curve, traders are usually referring to the spread between the yields. The most quoted spread is the one between the 10 year and the two year. As shown below, the spread has been narrowing in the past five years.