Is the inverted yield curve sustainable

Who's Afraid of the Inverse Yield Curve?

In mid-August, a small quake caused a stir on the New York stock exchanges.

Both the Dow Jones Industrial Index and the Nasdaq Composite Index went out of trading on August 14, each with sharp drops of more than 3 percent. The result was massive index losses on stock markets around the world.

In the days before, signals of easing in the trade dispute between the USA and China had actually created an excellent mood among investors. The US President had not made any conspicuous comments either. So what had caused the sudden slump in the stock markets?

What does the yield curve reveal about growth expectations?

In the US bond market, the yield on government bonds with a maturity of two years had risen above those on ten-year bonds. Such a rare situation creates an inverse yield curve. The last time this happened was in 2007, and all recessions in the US economy over the past five decades have been preceded by an inverse yield curve. Therefore, it is considered a reliable harbinger of a recession.

Because when investors lend money to the state, they are usually satisfied with a lower return on short-term bonds than on bonds that have a term of ten or more years. The logic behind this is simple: the shorter the term, the more manageable the risk of the investment and thus the required interest rate decreases.

Why does the inverse yield curve play such a big role?

An inverse yield curve suggests that this view of investors has been reversed. They then consider the short-term risk to be higher than that for longer-term investments. In other words, they think it is possible that economic growth will soon slow down so much that it will be more difficult for the state to repay its debts.

At the same time, they expect lower interest rates in the long term because they assume that the central banks will have to help the economy with cheaper money.

In this environment, it is also becoming more expensive for companies and consumers to borrow money at short notice. They therefore postpone investments and purchase decisions because they assume that interest rates will be cheaper again at another point in time.

This reduces investment and consumption, which make up a large part of economic activity, and so actually reduces economic growth.

Why did the yield curve turn?

The return on short-term bonds depends heavily on the interest rate policy of the respective central bank, because the key interest rates have a significant impact on the attractiveness of other financial products. Long-term government bonds are more likely to be shaped by inflation expectations, as investors pay particular attention to value stability with long maturities.

Over the past few years, the Federal Reserve (Fed) has gradually hiked interest rates, boosting two-year bond yields. When it surprisingly announced in March that it would ease monetary policy again, the yield curve normalized again.

But when the Fed cut interest rates for the first time since 2008 in July, the yield curve flattened further and finally inverted.

The reason for this is the growing concern that global growth weakness will continue to spread, driven by trade conflicts, and that a looser monetary policy alone will no longer be able to counter this.