A. Earlier this month the markets experienced a significant uptick in volatility, coinciding with an “inversion” of the yield curve, where longer-term yields on government bonds dipped below the shorter term yield.
Why Inverted Yield Curve Matters?
An inverted yield curve is significant because most of the time, interest rates are a combination of expected inflation rates and expected real interest rates, on top of which there is a maturity premium (i.e., higher yield) on longer-term bonds to compensate for their longer duration and higher risk. As a result, the yield curve typically only inverts if investors are anticipating significantly lower rates in the future and thus are trying to lock in higher current rates (at a cost of giving up their maturity premium).
Why would interest rates go lower in the future?
Either because the Fed keeps increasing rates (causing short-term rates to go higher), or expected long-term rates go lower because of an anticipation that the inflation rate will decrease, and/or the real interest rate will decrease… both of which tend to occur in a recession (and in response to which the Fed begins to cut interest rates, fulfilling the expected-lower-future-rates prophecy). In fact, an inverted yield curve has preceded (and thus effectively “predicted”) all 8 recessions that have occurred in the past 60 years, sending only one false signal (an inverted yield curve that didn’t actually turn out to be a recession) in the mid-1960s.
How to evaluate the slope of yield curve?
However, as Damodaran notes, there are many different ways to evaluate the slope of the yield curve (e.g., 3-month vs 1-year Treasuries, or 2-year vs 5-year Treasuries, or 2-year vs 10-year Treasuries), and not all of the yield curve comparisons are currently negative… and in cases where the yield curve is even “just” flat or remains very slightly positive, often economic growth resumes and a recession never actually occurs. Nor is there necessarily always a connection between inverted yield curves and future stock returns, either (as markets sometimes already have anticipated the recession before the yield curve inverts anyway, and by the time the inversion comes the bottom is already near). Nonetheless, the fact that at least some parts of the yield curve have started to invert does raise some potential warning signs about the economic outlook heading into 2019.