How does inverted yield curve indicate recession?

[ConfusedInvestor]

This is taken for granted in the general news media that an inverted yield curve is an indicator or a recession. How is an inverted yield curve a sign of an economic recession?

 

[Panic!]

Because it signifies that market participants see uncertainty in the near future and want to be compensated for that.

In a normal situtuation, interest rates are higher in the distant future than the near future. This makes sense because of the time value of money, and the fact that the distant future is more uncertain than the near future.

When this inverses, it means that there is some sort of expectation of unrest/turmoil in the near future.

 

[ConfusedInvestor]

So yield curves are based entirely off of interest rates on treasury securities? If that is the case, then how are the market participants setting the interest rate? I thought the FED did that themselves based on inflation prevention, controlling unemployment, etc.?

 

[Panic!]

Right, think I might have been clearer on the difference of interest rate vs yield.

If people start selling fixed income instruments, the price of the instrument goes down. Say we're talking treasuries. If the price of a treasury goes down, it is cheaper to buy, but you still get the same interest rate (based on original notional/face value). Thus the yield is higher.

So investors are indeed not setting the interest rates, but they do drive the price down, thus increasing the yield.

I suck at explaining things clearly, so I hope this makes sense to you

https://www.investopedia.com/terms/b/bond-yield.asp

 

[ConfusedInvestor]

Right, think I might have been clearer on the difference of interest rate vs yield.

If people start selling fixed income instruments, the price of the instrument goes down. Say we're talking treasuries. If the price of a treasury goes down, it is cheaper to buy, but you still get the same interest rate (based on original notional/face value). Thus the yield is higher.

So investors are indeed not setting the interest rates, but they do drive the price down, thus increasing the yield.

I suck at explaining things clearly, so I hope this makes sense to you

https://www.investopedia.com/terms/b/bond-yield.asp

Overall you have explained it pretty clearly, but i generally want to know about all the aspects and factors when it comes to financial instruments which can get pretty complex and confusing. Often finding specific information i want in terms of investing is more difficult than I would think in the era of ultra-information.

Which treasury securities can be sold? I know that TIPS can be sold, which other one's can? I buy 4-week treasury bills and i just wait 4 weeks and the money is back in my bank account.

 

[Panic!]

See if you can find the ICMA fixed income courses, that's what I went through about 10 years ago and there it is explained pretty well. Sure you can find the pdf versions somewhere.

As of which specific securities can be traded by a retail investor, no clue. Don't touch that stuff myself.

 

[new_trader]

Which treasury securities can be sold? I know that TIPS can be sold, which other one's can? I buy 4-week treasury bills and i just wait 4 weeks and the money is back in my bank account.

TIPS are inflation protected securities. You can also buy just standard 'fixed' securities.

It's not as simple as you think. Bonds/Gilts/Treasuries have:

1) Face Value: (The value of the bond when first issued by a Govt)
2) Coupon: The interest rate paid on the face value
3) Maturity date/Time: The date the bond matures

If you buy a bond and hold it until maturity you will receive the coupon payment based on the face value (NOT the price you paid) and likewise, only the face value is paid on maturity. These are all adjusted in the case of an indexed/inflation protected bond, which is adjusted in line with CPI.

You need to look at Yield to maturity to see what the return on your investment is. There are various calculators available to help you figure out the value of the bond and what your return will be.

 

[hatemypips]

This is taken for granted in the general news media that an inverted yield curve is an indicator or a recession. How is an inverted yield curve a sign of an economic recession?

Investors and traders start to expect lower future rates that's why it becomes profitable to buy long-term bonds now instead of purchasing short-term and then rolling over proceeds at future rate. That forces long-term yield to move down and short-term yields to increase.

 

[tradegreek]

Investors of bonds demand to be compensated for time risk (which incorporates other kinds of risks changes in interest rates, inflation etc). Therefore under normal conditions, you should have an upward sloping yield curve the 30 yr > 10 yr > 1 yr > 1month etc.

Yield is a function of price and coupon relative to other bonds but in terms of fixed income, it's fixed at inception unless it has a floating element which is not applicable as far as I am aware to government bonds. Remember that government bonds (US) are seen as risk-free. Therefore, we do not (although we theoretically could) price in default. Price, therefore, is more or less purely a function of supply and demand for a risk-free income.

Therefore, if prices rise yields fall if prices fall yields rise.

If the yield curve inverts then investors are purchasing the long-dated bonds to such a degree that the yield drops below near term yields (pushing the back end of the curve down). This is because expectations are that the market will fall therefore interest rates will fall in an attempt by central banks to stimulate the economy. At the same time investors may be selling short term bonds to buy long term bonds increasing short term yields (pushing the front end of the curve up).

This inversion of the yield curve doesn't have to lead to a recession but all recessions have an inverted yield curve prior to the recession.

 

[hatemypips]

Investors of bonds demand to be compensated for time risk (which incorporates other kinds of risks changes in interest rates, inflation etc). Therefore under normal conditions, you should have an upward sloping yield curve the 30 yr > 10 yr > 1 yr > 1month etc.

Yield is a function of price and coupon relative to other bonds but in terms of fixed income, it's fixed at inception unless it has a floating element which is not applicable as far as I am aware to government bonds. Remember that government bonds (US) are seen as risk-free. Therefore, we do not (although we theoretically could) price in default. Price, therefore, is more or less purely a function of supply and demand for a risk-free income.

Therefore, if prices rise yields fall if prices fall yields rise.

If the yield curve inverts then investors are purchasing the long-dated bonds to such a degree that the yield drops below near term yields (pushing the back end of the curve down). This is because expectations are that the market will fall therefore interest rates will fall in an attempt by central banks to stimulate the economy. At the same time investors may be selling short term bonds to buy long term bonds increasing short term yields (pushing the front end of the curve up).

This inversion of the yield curve doesn't have to lead to a recession but all recessions have an inverted yield curve prior to the recession.

Markets expect interest rates to fall not because of Central bank stimulus actions but because investing in longer-dated bond will yield higher return that investing in short-term and then rolling over proceeds investing into next short-term bond.

Consider an example of next two alternatives: investing in 2-year bond vs. investing in one-year bond and then reinvesting proceeds into one-year bond again at future rate. No arbitrage condition says that:

(1+s)(1+f)=(1+k)^2

where s is interest rate for one year bond, f - future rate for one-year bond, k - interest rate on 2 year bond.

if an investor believe that f will fall then (1+s)(1+f) < (1+k)^2 and investor will prefer to quit investing into two-year bond forcing its rate to go down. If he held 1 year bond before adjusting portfolio, then he has to sell it forcing one-year rate to go up

 

[britkid99]

Banks make money by borrowing cheaply at short term rates then lending for a longer term at a higher rate. When they can't do that due to an inverted yield curve, lending declines which ultimately ends in recession.

 

[hatemypips]

You raised great point, but basically it happens due to Central banks' actions because they signal that interest rates will remain low for a long time and investors start to jump to long-term bond what inverts yield curve too. I would say that there is a mix of factors and our goal is to decipher their impact to single out the strongest and then make proper market bets.