Author Topic: Why would inverted yield curve happen and why would that lead to recessions?  (Read 455 times)

muscleman

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I've been reading public pundits saying this a lot lately which gets me confused. Why would 2 year treasury yield ever be higher than 10 year? Who would be dumb enough to buy the 10 year notes then?
And how would this always be the precursor to recession?


KJP

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I've been reading public pundits saying this a lot lately which gets me confused. Why would 2 year treasury yield ever be higher than 10 year? Who would be dumb enough to buy the 10 year notes then?
And how would this always be the precursor to recession?

There is another active thread on this issue that began a few days ago: http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/yield-curve-inverting/

An inverted yield curve does not cause a recession, as your topic title suggests.  It is used as a leading indicator of potential future recession. 

As for why anyone would buy the 10-year note, a 10-year note is the equivalent of rolling a two-year note several times with a significant difference:  The 10-year note locks in a yield on cost for a 10-year period; the two-year note only locks in a yield on cost for 2 years, then you get the two-year yield that exists at the time you roll, not the two-year yield you got when you initially invested.  Thus, an inverted yield curve implies that the market believes that, in the future, short-term rates will be lower than they are today.  (If the market believed that short-term rates would stay the same, then people would sell their 10-years to buy 2-years until the yield curve steepened.)  What typically causes a decline in short-term rates?  The answer to that question is why the inverted yield curve is used as a leading indicator of recession. 
« Last Edit: December 06, 2018, 08:23:54 AM by KJP »

TwoCitiesCapital

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I've been reading public pundits saying this a lot lately which gets me confused. Why would 2 year treasury yield ever be higher than 10 year? Who would be dumb enough to buy the 10 year notes then?
And how would this always be the precursor to recession?

There is another active thread on this issue that began a few days ago: http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/yield-curve-inverting/

An inverted yield curve does not cause a recession, as your topic title suggests.  It is used as a leading indicator of potential future recession. 

As for why anyone would buy the 10-year note, a 10-year note is the equivalent of rolling a two-year note several times with a significant difference:  The 10-year note locks in a yield on cost for a 10-year period; the two-year note only locks in a yield on cost for 2 years, then you get the two-year yield that exists at the time you roll, not the two-year yield you got when you initially invested.  Thus, an inverted yield curve implies that the market believes that, in the future, short-term rates will be lower than they are today.  (If the market believed that short-term rates would stay the same, then people would sell their 10-years to buy 2-years until the yield curve steepened.)  What typically causes a decline in short-term rates?  The answer to that question is why the inverted yield curve is used as a leading indicator of recession.       

+1

In simpler terms, you get more bang for your buck buying 10-year bonds, than 2-year bonds, when interest rates fall.

If you think they're going to fall, you want 10-year bonds regardless if 2-years yield more because you're buying for the capital appreciation of the trade and not the YTM.

Cigarbutt

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Will stay at the pundits level and share off-topic anecdotal experience.
Been phoning around to coordinate Holidays gatherings and, during mundane conversations, the curve inversion does not come up but main street people meeting mortgage renewal deadlines seem to be considering variable rates. Dumb?
https://www.theglobeandmail.com/investing/personal-finance/household-finances/article-bank-of-canada-move-boosts-appeal-of-variable-mortgages-over-fixed/

Around 2016, there was another seemingly unrelated phenomenon: about 30% of global sovereign debt was trading at a negative yield. Dumb? Not bright enough to explain both phenomena but bright enough to wonder if both do not share the same root cause.

I guess people tend to choose the best worst case opportunity?

Back to the distant relatives and other Canadian acquaintances, it seems that they could manage things differently but who I am to judge?What's clear is that some are struggling to balance at the end of each month and the Bank of Canada's tone on rates seems to have something to do with it.
https://www.nbc.ca/content/dam/bnc/en/rates-and-analysis/economic-analysis/hot-charts-181130.pdf