Following on from a previous post about the inverted yield curve, The Economist have produced a very good video explaining how when the outlook is gloomy investors turn buy safe assets like long-term bonds, pushing their price up so the interest rate for holding them falls. Higher bond prices are also a signal that there are fewer exciting investment opportunities elsewhere such as the stockmarket. Unemployment is also an indicator that closely correlates with a recession and even R index* can fuel recessionary expectations. There are some particularly good graphs in the video.
*The recession index (the R-word index) is an informal index created by The Economist which counts how many times the word ‘recession’ is mentioned in the Washington Post and the The New York Times in a quarter.
There has been a lot in the news about the ‘inverted yield curve’ which occurs when interest rates on short-term ends are higher that the interest rates paid on long-term bonds – see video below from WSJ. Here we are talking about 2 year bonds in relation to 10 year bonds. The thinking is that people are so worried about near-term future that they are putting money into safer long-term investments.
When an economy is growing at steady rate bondholders want a higher yield (return) on longer-term bonds than for short-term bonds. The rationale behind this is that if your money is tied up for a longer period of time (10 year bond) you want to be rewarded for that risk. In contrast bonds that require shorter time commitments don’t require as much sacrifice and usually pay less.
However this week the yield on 10 year bonds fell below the yield on 2 year bonds for the first time since 2007 – remember this was followed by the GFC. The chart below shows the difference in the yield between 2 year and 10 year bonds – as stated bonds of longer duration should have a higher yield. What is significant is that the inverted yield curve has occurred before every US recession since 1955 and is viewed as a strong predictor of a recession / downturn. If people are willing to take such little money for their long-term bonds it would indicate that inflation is not a concern.