What Does it Tell Us?
Similarly, in a normal economic environment, the interest rate on a U.S. Treasury bill maturing in three months is lower than on a US Treasury note maturing in ten years. Since the U.S. government issues many different maturities of bills, notes and bonds from one month to thirty years, we can create a graph using all these rates called the yield curve. Because US Treasury debt is considered the highest level of credit quality, the treasury yield curve is considered a fairly pure indication of US inflation and deflation risk. See the drawing below of a normal yield curve.
Unfortunately, the Fed often raises rates too fast or too much and not only slows the economy but tips it into a recession. When market participants think an economic slowdown will turn into a recession, they typically expect future inflation to fall. In this scenario, investors buy more long-term treasuries causing long term interest rates to fall. With short-term rates rising because of Federal Reserve actions and long-term rates falling because of investor buying... you get an inverted yield curve.
Why do investors buy long-term Treasury bonds when they fear a recession? They expect businesses to do poorly and consider US government debt the safest asset to own. They also expect the Fed to do an about face and reduce interest rates to re-stimulate the economy. Eventually this Fed stimulus leads back to a more normal yield curve, and we will have gone full circle.
Although the yield curve has inverted two separate times this year, many economists think the inversion should stick around for a couple months in order to give a clear recession signal. The May inversion has lasted almost three weeks... so stay tuned.
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