Recently in the news there’s been a lot of chatter about the  “crazy inverted yield curve”. As it’s a much talked-about economic topic, we wanted to explain this inverted yield curve, why it happens and what it means for the economy.

When speaking about the inverted yield curve, the president was referring to the rates offered by the government on the US Treasury Bonds. Let’s dig deeper into that.

Long versus short term rates and yields

Yields are the effective application of a rate upon a deposit. If you want to understand how it works, you can find out on our article on compound interest.

However, to explain yields on bonds in layman’s terms, think of OAS FCU’S Share Certificates. In a share certificate you make a deposit for a specific period of time, during which you can’t touch the money. In exchange, you get better interest rate (and, once applied, yield) for it. The longer the term of the certificate, the higher the rate that we offer you. Why? Because you’re taking a greater risk by leaving the money untouched for a longer period of time.

Treasury bonds

Well, Treasury bonds are just like CDs; it’s just that it’s the U.S. government selling them instead of a bank or credit union. You provide the government money for a set period of time, and they give you interest for it.

Now, every other day, the idea is that the longer term bond you purchase, the more interest they offer to pay you. That makes sense, like with a share certificate or CD from a bank. That’s why normal yield curve would be like the Daily Treasury yield curve from May 2018 shown here, where the more time one invested, the higher the rate of return, or yield (source: Wikipedia).

But every now and then, the US Treasury changes the rates drastically, offering us a higher rate for a short-term investment rather than a long-term one. And that’s then the yield curve inverts.

Why it happens

There are several reasons why the U.S. Treasury might make its short-term yields higher than the longer term ones:

• Monetary policy. If the government wants to increase the Fed Funds rate (the overnight rate), it will issue bonds with better rates so as to restrict the amount of money in circulation. Because of the law of supply and demand, the less of an item there is, the higher the price. That includes actual money, so with less U.S. dollars in the economy, rates would go up. That’s because rates are the value one pays for money itself.
• Fiscal (tax) policy. When the government has a deficit, it can obtain money from investors by issuing bonds. That’s because, as seen from the U.S. government’s side, issuing bonds means they get a loan from investors for which they pay an interest rate (the yield).
• To control inflation. When there’s an inflationary problem, the government can control the Consumer Price Index by removing money form circulation. Because bonds decrease the supply of money, its value goes up and prices, conversely, go down.

A global economic view

While any reason above is plausible, none of three of the cases apply right now to the U.S. economy. The Fed just dropped rates, and right now inflation is well under control, at 1.8% so far this year. And while the United States is indeed running a deficit, it has been doing this for a while now and the Treasury didn’t show any signs of tackling that until now. So why the flip?

This change responds directly to investor faith in the economy. It starts with global forecasts becoming weaker by the day. There are concerns about the effects of a hard Brexit on the EU: Britain’s economy shrank in the second quarter of this year (so did Germany’s, for that matter). Mexico is skirting the same issue, and Brazil’s economy seems to be shrinking as well. Italy’s growth has flatlined. China is still growing but that growth is flattening out while unemployment is surging. All these countries are among the world’s 20 largest economies, so the indicators don’t bode well.

Investor faith in the U.S.

The trade war with China has global and domestic investors alike worrying about investing in the United States. What products will get tariffs, what will get trade restrictions or even bans next? Confidence in investment on the big sellers in the United States –consumer goods and electronics- is dropping away, dragging faith in related sectors with it. When all else fails, what do investors do? They turn to the short-term safe bet: bonds. The demand for them goes up, and with that, their price (the rate/yield) does, too.

What this means, historically and now

In the past 50 years, every time the yield curve flipped on U.S.-backed securities, it forecasted a recession within 22 months on average. Based on this, it became an investor comparison to gauge how the economy was doing. So, right now the yield curve has flipped, investors are getting spooked and leaving the market. The news outlets go all ‘doomsday economy’, social media adds fuel to the fright, while experts clamor for everyone to calm down. And we mortals are going “oh boy, is it happening again?”

Whether it is a factual indicator or something that will become a self-fulfilling prophecy makes no difference. It is happening and now is the time to see what can be done to soften the likely-upcoming blow.