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Why normal yield curve is no longer our reality !



What is a yield curve ?


Yield curve represents the nature of yields through time. It tells us how much yield, investor is expecting for different time horizons.


Naturally, if an investor is investing for a longer time, he/she will demand higher yield because uncertainty of the investment increases with time. Which is why, yield curve should be upward sloping.


But this is not the reality we are living in!



This the chart of 10Yr yield minus the 2Yr yields


This effectively means that the investors are demanding more return for investing in a 2Yr US government bond than they are for a 10Yr bond.


In each of the 3 times this curve was inverted, something in the system broke and there was severe pain in the stock market.


And to make matters even worse, this time, the inversion is the steepest and for the longest duration !


Yield curve inversion has proven to be a reliable indicator of economic downturns in the past. It has preceded almost every recession in the United States over the past 50 years. This historical significance has made it a crucial tool for economists and analysts to monitor and predict changes in the economic landscape.


Why Does Yield Curve Inversion Matter?

Yield curve inversion holds immense importance due to its implications for the economy and financial markets. Understanding its significance can help investors and policymakers make informed decisions. Let's explore the key reasons why yield curve inversion matters:


1. Recession Indicator


As mentioned earlier, yield curve inversion has often preceded economic recessions. When the yield curve inverts, it signals a potential economic downturn in the near future. This information is vital for investors, as it allows them to adjust their portfolios accordingly and take preventive measures to safeguard their investments.


2. Impact on Financial Institutions


Financial institutions, such as banks, heavily rely on the spread between short-term and long-term interest rates to generate profits. Yield curve inversion can squeeze this spread, affecting the profitability of these institutions. As a result, banks may become more cautious in lending, leading to a slowdown in economic activity.


3. Influence on Monetary Policy


Central banks and policymakers closely monitor the yield curve to gauge the state of the economy and determine appropriate monetary policy actions. Yield curve inversion can prompt central banks to implement measures to stimulate economic growth, such as lowering interest rates or implementing quantitative easing programs.


4. Investor Sentiment and Market Volatility


Yield curve inversion often leads to heightened market volatility and investor uncertainty. When investors witness the inversion, they may interpret it as a sign of impending economic troubles, leading to panic selling and market downturns. This increased volatility can impact various asset classes, including stocks, bonds, and commodities.



 

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