U.S. Treasury yield curve: Under normal circumstances, short-term U.S. Treasury bond interest rates are low, and long-term Treasury bond capital flows are subject to certain restrictions, so interest rates are higher. This is a common phenomenon in healthy markets. However, we can see from historical development that sometimes short-term interest rates are higher than long-term interest rates, which is called an "interest rate inversion." The most important thing is that such abnormal trends are often followed by economic recession. As a result, analysts draw interest rate curves based on interest rate trends and make certain analysis and trend predictions about the market. What does the interest rate curve mean to investors? At the same time, the yield curve is also used to predict changes in economic output and growth. A normal curve tends to indicate positive economic expansion, while a downward sloping curve (inversion of interest rates) indicates economic recession. In a flat yield curve, short-term and long-term yields are very close. What types of yield curves are there? There are three main types of yield curves: Normal yield curve, which is an upward sloping curve flat yield curve An inverted yield curve, a downward sloping curve 1. Normal yield curve This upward sloping yield curve is the most common for U.S. Treasury bonds in Treasury bond investments. According to the pattern of treasury bond issuance, the higher the time risk investors bear, the higher the benefits they obtain. Therefore, long-term interest rates tend to be higher than short-term interest rates. So, it can be seen that along the x-axis, interest rates are growing. For example, if a two-year Treasury bond yields 1%, a five-year bond yields 1.8%, a 10-year bond yields 2.5%, a 15-year bond yields 3.0%, and a 20-year bond yields 3.5%. In this case, the interest rate on long-term Treasury bonds is always higher than the interest rate on short-term Treasury bonds. A normal yield curve indicates current stable economic conditions, while a steeper yield curve indicates that investors believe the economy will grow strongly in the future. 2. Flat yield curve If the yield curve becomes flat, that is, the yields on different maturities are not much different. A flat yield curve indicates that Treasury bonds of different maturities have similar yields. For example, on December 4, 2018, the yield on 1-year Treasury bonds was 2.71%, 3-year Treasury bonds were 2.81%, and 5-year Treasury bonds were 2.79%, which are not much different. This results in a slight hump along the flat curve. A flat or bulging yield curve indicates uncertainty about the economic situation, indicating that the market believes that the Federal Reserve may cut interest rates to some extent to stimulate the economy. In such a situation where the market situation is unclear, investors prefer a more average rate of return. 3. Inverted yield curve (interest rate inversion) A downward-sloping yield curve is called an inversion curve. At this time, the yield on short-term Treasury bonds is higher than the yield on long-term Treasury bonds, which can also be understood as an "interest rate inversion." For example, the 10-year Treasury bond yield is 4.37%, which is lower than the 1-year Treasury bond yield of 4.38%. Inverted interest rate curve, English name: Inverted Yield Curve. It is an interest rate curve where long-term bond rates are lower than short-term bond rates. This is an unusual situation that often signals an impending economic stagnation or recession. Interest rate inversion is not common. Judging from historical data, the occurrence of interest rate inversion usually indicates that economic development will seriously slow down or even reverse. At this time, the Federal Reserve may cut interest rates significantly to stimulate the economy and prevent deflation. In addition, during periods of uncertainty about the economic outlook, investors seeking safe investments are more likely to purchase long-term bonds than short-term bonds, thereby raising the price of long-term bonds and lowering their yields, leading to an interest rate inversion. Why does interest rate inversion happen? The demand for bonds is linked to their yield. When demand is high, the government can sell enough bonds without offering high interest rates, while bonds with low demand need to offer higher interest rates to attract more investors. Under a normal economic environment, investors want to invest flexibly in the short-term market, so short-term bond purchases are large and interest rates are low, while long-term bond purchases are relatively small and interest rates are higher. However, when investors lack confidence in the near-term economy and believe that the economy will become very bad in the short term, and the near-term risks of investment are greater than the forward-term risks, investors are more willing to buy long-term government bonds.
As investors piled into long-dated bonds, the prices of those bonds were bid up and yields began to fall. The demand for short-term Treasury bills fell, so the government offered higher yields to attract investors, eventually causing an interest rate inversion. What might an interest rate inversion mean? An inversion in interest rates is a sign of investors' lack of confidence in the recent economic market. Due to the relationship between bond demand and interest rates, the interest rates of bonds with different holding periods are not only a reflection of the development of the market economy, but also a prediction of future economic trends. When interest rates are inverted, that is, short-term bond interest rates rise and long-term bond interest rates fall, it means that investors are not optimistic about the recent economic performance and are unwilling to invest in short-term bonds. When they reinvest after the short-term bonds mature, they will not get good returns, so they transfer funds to long-term bonds. The overall market atmosphere that is not optimistic about the short-term economy often indicates the possibility of an economic crisis in the near future. However, economic recession does not necessarily occur as long as an interest rate inversion occurs. Occasional interest rate inversions may be due to some special circumstances that cause people to change their investment strategies. Such interest rate inversions can be flipped back to the normal curve through self-regulation by the market or slight regulation by policies. If interest rates remain inverted for a period of time, it could signal a recession. When the interest rate inversion lasts for more than half a year, such as the interest rate inversion before the energy crisis in the 1980s, which lasted for more than two years, it will become a clearer indicator of economic crisis. And the longer the interest rate inversion lasts, the greater the possibility of an economic crisis. During an interest rate inversion, financial market turmoil does not necessarily occur. Market turmoil usually occurs several months after the interest rate inversion ends. How to track an interest rate inversion? In addition to looking at the shape of the yield curve on a daily basis (normal, flat, or inverted), we can also track it by calculating the difference between long-term Treasuries and short-term Treasuries. For example, 10 Year Bond Yield can be used to represent long-term Treasury bonds, and 1 Year Bond Yield can be used to represent short-term Treasury bonds, so as to monitor whether the difference between the two is less than 0. The calculation formula is as follows: Yield Difference = 10 Year Bond Yield – 1 Year Bond Yield If the Yield Difference here < 0, it can be considered that an interest rate inversion has occurred, which is an important warning signal. For short-term treasury bonds, you can also use the 3-month treasury bond yield or the 2-year treasury bond yield for calculation. Below is the yield difference between the 10-year Treasury bond and the 1-year Treasury bond. [amcharts id=”chat-inverted-yield-curve”] As can be seen from the figure, any curve below the red line is the part where interest rates are inverted. Have interest rate inversions occurred historically? The reason why interest rate inversion is worrying is that it has been more accurate in predicting the outbreak of economic crises several times in the history of economic development. There was a sustained interest rate inversion from 1978 to 1981, which led to the economic recession from 1980 to 1982 due to the energy crisis. Interest rates inverted for several months in the first half of 1989, leading to a recession in 1991 due to the debt crisis. Interest rates were inverted throughout 2000, and the Internet bubble led to an economic recession from 2001 to 2003. Interest rates inverted from December 2005 to September 2007, followed by a severe economic recession in 2008 due to the subprime mortgage crisis. The following is the Treasury yield rate before the 2008 financial crisis:
The first inversion occurred on December 22, 2005. At that time, the Federal Reserve was worried about the asset bubble in the real estate market and raised interest rates. In the market, the growth rate of the two-year Treasury bond yield was higher than the growth rate of the ten-year Treasury bond yield, and investors were more willing to invest in the ten-year Treasury bond. The situation lasted until July 2006, when the ten-year Treasury yield was 5.07% and the two-year Treasury yield was 5.12%. However, the Federal Reserve at the time did not take the interest rate inversion seriously, believing that lower long-term yields would provide the economy with sufficient liquidity to prevent a recession. When the interest rate inversion continued into September 2007, the Fed finally became concerned and tried to stimulate the market with successive interest rate cuts. It was not until the end of 2008 that the federal funds rate was lowered to zero, which meant that banks borrowed money from each other without paying interest to stimulate economic recovery, and the yield curve stopped inverting, but it was too late. The market economy has entered the most serious recession since the Great Depression. The yield curve in recent years The most recent interest rate inversion occurred in August 2019, when the U.S. Treasury yield curve inverted for the first time since the recession. At that time, the 1-year Treasury bond yield was 1.73%, which was higher than the 10-period Treasury bond yield of 1.52%. Risk aversion has caused more investors to flock to the U.S. Treasury market. The Federal Reserve changed its stance and began to cut interest rates, but investors were worried that the Sino-US trade war at that time would further lead to an economic recession. FAQ