By Neil Szczepanski, Tradeology: The Fifth Insight
We have all heard it – “As the yield curve slips towards inversion, the recession warning light blinks red—again.” But, do we all know what this means? In order to understand the effect of a yield curve inversion, we must first understand what a yield curve inversion is and how it happens, along with the definition. Yield curve inversion represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality. More specifically, when we hear about this in the news, they are referencing the daily treasury yield curve rates. Particularly the 10-year compared to the three-month rates. In the diagram below, you will notice the 10-year T-Bill to be at 1.54 percent while the three month is at 1.57 percent. You will also notice the Yield curve went inverted January 30,2020.
The normal yield curve (blue) shows higher yields for longer periods of time. The inverted yield curve (red) shows lower interest rates for longer periods of time. Normally, lenders receive a better yield when they loan money for longer periods of time.
Of the three main curve types- normal, flat and inverted- an inverted yield curve is the rarest, and it considered to be a predictor of economic recession. This has historical precedence and is seen as a way to predict the turning points of the business cycles. Because of the rarity of yield curve inversions, they typically draw attention from all parts of the financial world.
So, why do we care as traders? As traders we need to be aware of all things affecting the market, especially if we are using a buy and hold strategy. The yield curve inversion tells us interest rates are going to fall. When interest rates fall the federal reserve will feel the need to institute a stronger Quantitative Easing (QE) policy. When interest rates fall, so do the financials which can take the entire market down. Recessions usually cause interest rates to fall. Inverted yield curves are often, but not always, followed by recessions. As investors can use this data to help formulate our directional bias in our trades.
At Tradeology the Fifth Insight we look at these types of market concepts and discuss how we can use this information to help make better decisions, To learn more about this and other trading strategies visit Tradeology The Fifth Insight.
Disclaimer: The author is not a financial advisor and the following should not be taken as financial advice. This is by no means a complete discussion of the pros and cons of trading and/or investing. Please consult your own qualified advisors to determine what is appropriate and best suited to your specific investment objectives and risk tolerance.