The yield curve is reversed. What does it mean?

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The three major US stock indexes fell on Friday as investors reacted to one of the key indicators of the recession: the so-called reversal of the yield curve between 10-year and three-month Treasury bonds.

the
Dow Jones Industrial Average
and the
S & P 500
each about 1.5% around noon, while the
Nasdaq
was out almost 2%.

The yield curve represents the difference between long-term and short-term Treasury bond yields. A reversal of the yield curve occurs when long-term returns are lower than short-term returns. It has always been considered a reliable indicator of future recessions.

Why? Although the short-term side of the yield curve is primarily related to the Federal Reserve policy reflecting the current economic strength, the long-term end of the yield curve – Treasuries to 10 years and over, – is meant to indicate long-term investors. long-term views of the market.

If bond investors are optimistic about the economy and believe interest rates will rise, they are more willing to hold short-term bonds and hope to reap higher returns later. On the other hand, if bond buyers believe that the economy is falling and interest rates are likely to fall, they prefer to hold long-term bonds to keep current yields higher.

In this case, the increased demand for long-term bonds will drive up their prices and lower yields. Long-term bond yields are generally higher in economic expansions, as bond investors need more compensation to be tied up. However, when sentiment becomes too bearish, long-term returns may be lower than short-term returns.

That's what happened on Friday.

Experts are divided on the most reliable yield curve, but the Fed prefers to look at the curve between 10-year and three-month Treasury bonds, which turned negative on Friday to less than 0.196 percentage points.

A reversal of the yield curve preceded recent recessions, but it is not immediate and the delivery time is very inconsistent. Historically, a recession can occur from one to two years after the curve reverses, and the stock market generally continues to gain overnight from the inversion up to the peak of its cycle.

So we have more time to watch.

Write to Evie Liu at [email protected]