How does inverted yield curve indicate recession?

ConfusedInvestor

Junior member
14 2
This is taken for granted in the general news media that an inverted yield curve is an indicator or a recession. How is an inverted yield curve a sign of an economic recession?
 

Panic!

Member
63 9
Because it signifies that market participants see uncertainty in the near future and want to be compensated for that.

In a normal situtuation, interest rates are higher in the distant future than the near future. This makes sense because of the time value of money, and the fact that the distant future is more uncertain than the near future.

When this inverses, it means that there is some sort of expectation of unrest/turmoil in the near future.
 

ConfusedInvestor

Junior member
14 2
So yield curves are based entirely off of interest rates on treasury securities? If that is the case, then how are the market participants setting the interest rate? I thought the FED did that themselves based on inflation prevention, controlling unemployment, etc.?
 

Panic!

Member
63 9
Right, think I might have been clearer on the difference of interest rate vs yield.

If people start selling fixed income instruments, the price of the instrument goes down. Say we're talking treasuries. If the price of a treasury goes down, it is cheaper to buy, but you still get the same interest rate (based on original notional/face value). Thus the yield is higher.

So investors are indeed not setting the interest rates, but they do drive the price down, thus increasing the yield.

I suck at explaining things clearly, so I hope this makes sense to you :)

https://www.investopedia.com/terms/b/bond-yield.asp
 

ConfusedInvestor

Junior member
14 2
Right, think I might have been clearer on the difference of interest rate vs yield.

If people start selling fixed income instruments, the price of the instrument goes down. Say we're talking treasuries. If the price of a treasury goes down, it is cheaper to buy, but you still get the same interest rate (based on original notional/face value). Thus the yield is higher.

So investors are indeed not setting the interest rates, but they do drive the price down, thus increasing the yield.

I suck at explaining things clearly, so I hope this makes sense to you :)

https://www.investopedia.com/terms/b/bond-yield.asp

Overall you have explained it pretty clearly, but i generally want to know about all the aspects and factors when it comes to financial instruments which can get pretty complex and confusing. Often finding specific information i want in terms of investing is more difficult than I would think in the era of ultra-information.

Which treasury securities can be sold? I know that TIPS can be sold, which other one's can? I buy 4-week treasury bills and i just wait 4 weeks and the money is back in my bank account.
 

Panic!

Member
63 9
See if you can find the ICMA fixed income courses, that's what I went through about 10 years ago and there it is explained pretty well. Sure you can find the pdf versions somewhere.

As of which specific securities can be traded by a retail investor, no clue. Don't touch that stuff myself.
 

new_trader

Legendary member
6,181 1,258
Which treasury securities can be sold? I know that TIPS can be sold, which other one's can? I buy 4-week treasury bills and i just wait 4 weeks and the money is back in my bank account.
TIPS are inflation protected securities. You can also buy just standard 'fixed' securities.

It's not as simple as you think. Bonds/Gilts/Treasuries have:

1) Face Value: (The value of the bond when first issued by a Govt)
2) Coupon: The interest rate paid on the face value
3) Maturity date/Time: The date the bond matures

If you buy a bond and hold it until maturity you will receive the coupon payment based on the face value (NOT the price you paid) and likewise, only the face value is paid on maturity. These are all adjusted in the case of an indexed/inflation protected bond, which is adjusted in line with CPI.

You need to look at Yield to maturity to see what the return on your investment is. There are various calculators available to help you figure out the value of the bond and what your return will be.
 

hatemypips

Well-known member
315 11
This is taken for granted in the general news media that an inverted yield curve is an indicator or a recession. How is an inverted yield curve a sign of an economic recession?
Investors and traders start to expect lower future rates that's why it becomes profitable to buy long-term bonds now instead of purchasing short-term and then rolling over proceeds at future rate. That forces long-term yield to move down and short-term yields to increase.