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In the middle of last week, the US bond yield curve inverted. On 26 October, the yield on a treasury bond maturing in three months stood at 4.032%. In comparison, the yield on a treasury bond maturing in 10 years stood at 4.007%, implying that the yield on a three-month treasury was higher than the 10-year treasury. This is the first time something like this has happened since early March 2020, when the covid-pandemic broke out.

Treasury bonds are financial securities sold by the US government to finance its fiscal deficit or the difference between its earnings and expenditure. The yield on a bond at any point in time is the annualized return investors can expect to earn if they buy the bond at that point and continue holding it until maturity.

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Change of course
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Change of course

Typically, the longer we look into the future, the more uncertain it gets. Given this, the yields or returns on long-term bonds tend to be higher than short-term ones. Higher return essentially compensates investors for the higher risk and uncertainty of investment involved. This explains why, usually, the yield on a 10-year treasury bond is higher than a three-month one.

However, this basic logic broke down last week and the return on three-month bonds became higher than the return on the 10-year one. That’s how things stayed until Friday. If this trend continues, we will get an inverted yield curve.

A yield curve is essentially a plot of the returns of bonds of different maturities as a chart. Usually, given that bonds with longer maturities have higher yields, the yield curve slopes up from left to right as the maturities increase. But now, with the yield on a three-month treasury being higher than the 10-year one, the curve will slope down from left to right, meaning it will invert.

Indeed, bond investors are demanding a higher annualized return for investing in short-term American government bonds than long-term ones, suggesting that they are no longer very positive about the short-term and hence, want higher returns to be compensated for the higher risk, essentially implying that an economic recession is around the corner.

So, what will the US Federal Reserve do? A monetary policy meeting of the Fed is scheduled for 1-2 November. In the last three monetary policies, the Fed raised the federal funds rate, a key short-term interest rate, by 75 basis points each to slow down investment and consumption and control inflation.

With the yield curve inverting and an economic recession around the corner or probably already there, the question is whether the Fed will continue to aggressively raise rates to control inflation.

A bulk of the stock market investors clearly feel otherwise. The Dow Jones Industrial Average, America’s most popular stock market index, has risen by a huge 12.4% for the month ending 28 October. This suggests that the stock market believes that the Fed will now go slow on raising rates. The logic is that higher rates will lead to a deeper recession.

If the Fed does go slow on raising rates, it will further hurt its credibility as an inflation fighter. If stock market investors, on the whole, had taken the Fed’s credibility as an inflation fighter any seriously, they wouldn’t have continued pouring money into stocks.

This is despite the Fed having said it is very serious about raising interest rates and controlling inflation, even if that leads to higher unemployment. “We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t," Fed chairman Jerome Powell said in September.

It will be interesting to see which way Powell and the Fed lean, whether they will try to continue to control inflation by raising rates or take a break from doing that.

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