The concept of ‘Inverted Yield Curve’ can be easily related to the ‘The Curious Case of Benjamin Button‘- Hollywood’s fantasy drama movie.
In an ideal economic condition, a normal yield curve depicts low yield for short term papers (bills) with respect to the longer dated bonds (10-yr Treasury notes, 30-yr bonds).
But when the yields of short terms bills are higher than long dated bonds then it gives you an inverted yield curve. For those who are not aware of the movie, it was about a man who ages in reverse i.e. older to younger. So, an inverted yield curve is a very unusual case similar to Mr. Benjamin Button.
Going by the terms, concepts and theory of economics; generally, an investor expects low return from short term investment whereas high return from long term investment. But when the investor believes that short term investments are risky and long term investment are secure even though they offer less return- this gives the yield curve a whole new look – an inverted yield curve.
The mechanism behind inverted yield curve
Imagine, the investors expect rates cut by Fed in coming months as the economic conditions are not favourable ( a perfect case would be recession period ). Since the short term bills closely follow Fed rates, investors will dump those bills on the anticipation that these bills will follow the Fed rates soon. In return they will flock themselves with longer dated treasuries, creating demand for it, which will shoot up the prices and bring down yield for those treasuries in the market. As everyone is running behind longer dated bonds, there will be few buyer for short term bills who will eventually demand for high coupon rates or yield, resulting, change in the dynamics of treasury yield curve see the graph below.
Although it is very pertinent to notice that an inverse yield curve can be used to forecast the recession. Many economists and market pundits will agree that a change in a yield curve always sends signal that the economy might see some hiccups in coming times. In the U.S., the treasuries yield curve got inverted before the recession of 2008, 2000, 1991 and 1981. The inverted yield curve had got many curious moments in past. In July 2006 the debt market witnessed inverted yield curve which remained inverted for almost a year – till June 2007.
In the behest of cooling off the housing bubble the Fed increased its rate to 5.75 percent in 2006. After realizing the situation, in September 2007 it started cutting down rates consecutively ten times to near zero percent in 2008; the year which embarked official recession in the U.S. economy. One irony is ‘The Curious case of Benjamin Button’ got released in the same year – 2008.