Why an inverted yield curve fuels fears of recession

  • The yield curve has inverted in the US, so long-term bonds are paying the investor less than short-term ones. This has led Trump to call Fed chairman, his colleagues 'clueless'
  • Even as the world talks about negative interest rates, India continues to see high interest rates

The yield curve has inverted in the US, so long-term bonds are paying the investor less than short-term ones. This has led President Donald Trump to call the US Fed chairman and his colleagues “clueless". Mint tells you what the phenomenon means for the world economy.

What does an inverted yield curve mean?

Anywhere, anytime in life, a person/institution pays a lender more for a long-term loan than a short-duration one. The same rule applies when a bank takes a fixed deposit from you, though there can be small variations among various deposit terms borne out of market dynamics and the need for asset-liability matches. Quite the reverse is happening in the US. Interest rates (yields) on short-term bonds have moved ahead of those payable on long-term bonds. This also means investors worried about growth are investing in long-term bonds, pushing up their prices. Bond prices and yields move in opposite directions.

What does an inverted yield curve indicate?

Historically, when yield on the 10-year US government paper has fallen below the 2-year one, recession has followed there. On Wednesday, that’s what happened. At one point on Thursday as well, the yield on 10-year note was 1.5708% as against 1.5710% on 2-year although balance was later restored. Yields on three-month treasuries have ruled higher than 10-year note for five months, but the gap had widened Wednesday. This means bondholders are worried about economic weakness and not inflation which usually picks up in a growing economy. Developed economies have had low inflation for decades.

So, does this mean the US is staring at a recession?

Recession is defined as two straight quarters of negative growth. It may be a little early to say “yes". Walmart on Thursday reported strong earnings and US jobs growth remains strong.

Why is the yield curve inverting then?

Much of the blame has been put on the US-China trade spat. When it started over two years ago, there was hope it would get resolved as both sides kept the talks going. But a deal hasn’t come through even as Trump has put off the latest round of tariffs on Chinese imports (video games, smartphones, laptops, toys) to 15 December. Tariffs on tools, apparel and some footwear take effect on 1 September. The trade tiff between the two largest economies is creating uncertainty and investors are rushing to buy US bonds, a safe haven.

Is India witnessing a similar situation?

No, but India’s economy is facing other problems. Its financial sector is grappling with trillions of rupees in bad debt and resolution of most cases is still slow. Fear of probe agencies over fresh bad debts and a liquidity crunch are hampering lending by banks. Even as the world talks about negative interest rates, India continues to see high interest rates. Its 10-year bond yield rose for the fifth consecutive session on Wednesday and closed at 6.6%—a level last seen on 4 July. The country is still the second fastest growing large economy.

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