Understanding The Concept Of Inverted Yield Curve

inverted yield curve

The inverted yield curve is something which the market participants expect not to face as this type of yield curve reflects that the economy is being headed in the wrong direction and soon there could be an economic recession. Let us first quickly understand what is inverted yield curve. An inverted yield curve happens to be a situation where the shorter duration instruments advance higher yields as compared to the instruments which are having a longer duration. Please note that the instruments which have been referred here would mean debt instruments like bonds, bills etc. It must be noted that the debt instruments which have been referred here need to be having same credit quality.

It would also be of interest that some of the global investors are presently fearing economic recession because of the worries of the global economic slowdown, unfavorable momentum in the oil and stock markets and problems in the global trade environment. The unfavorable geopolitical and macroeconomic factors might lead to global slowdown, thus, increasing the worries for the economic recession.

There are expectations that the Fed would raise the rates twice in 2019 while earlier there were expectations for three rate hikes. However, the investors were expecting more slower rate increases. In the situation of the inverted yield curve, the market players deploy their investable capital in the bonds which are for a longer period of time. For example, consider two debt instruments having the same credit quality. One has a maturity of 5 years while the other one has a maturity of 10 years. The inverted yield would be a situation when the 5-year bond offers higher yields as compared to the yields offered by the 10-year bond.

Therefore, if 5-year bond advances the yield of 3.5% while the 10-year bond gives 2.5% yield, it would make the yield curve inverted. This clearly represents the situation which would be detrimental to the health of the broader economy. If at any point in time the yield curve inverts, it would mean the economic recession might occur in the near future. The primary reason why some of the market participants are expecting that the recession might occur because of the current economic conditions. There are worries about the global economic slowdown largely because of the unfavorable momentum in the financial markets. However, to determine the overall health of the economy other market participants are also taken into consideration like oil markets.

The macroeconomic conditions prevailing in a particular economy effects the broader business environment of that economy. Therefore, if the macroeconomic conditions are favorable, then the business and consumer confidence would be positive which would support the overall health of the economy. However, the tensions arise if the macro factors are unfavorable as this could be detrimental to the business and consumer confidence. The geopolitical worries also impact the business sentiments. Weaker business sentiments would mean that the business activities or investments would fall, and lower consumer confidence would mean that the retail spending would encounter a decline.


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