Simplifying the Inverted Yield Curve

XP Invest
August 15, 2019

Whether you invest in crypto, equity or some other asset class you probably heard about the inversion of the yield curve. What exactly does it mean, and should you be concerned?

Your first question could be, what is bond yield?

It is essentially the return an investor should expect on their investment (in a bond).

The next thing to understand is what a yield curve is. It is a line that plots interest rates at different points in time for bonds that have equal credit quality, but different points of maturity. The longer the maturity, the higher the interest as a reward for the risk. The yield curve can have different shapes.

An upward yield curve is upward sloping, and this shows that with time the yield increases because of the risk associated with holding bonds over a longer period.

https://www.frbsf.org/education/publications/doctor-econ/2004/july/yield-curve/

An inverted yield curve (which is what everyone is talking about), is downward sloping. It signifies that the longer investors hold on to their investments, they should expect the yield to decline. Therefore it is usually considered as a sign for future recessions which is what seems to be happening at the moment.

https://www.marketwatch.com/story/5-things-investors-need-to-know-about-an-inverted-yield-curve-2019-08-14

The yield curve for a 10-year bond has now dipped below the 2-year treasury bond. This is the first time that is has happened since 2007. When the Fed cuts rates, its usually to encourage spending and this causes a spike in the stock market. Unfortunately, it seems the news of the inverted curve has overshadowed the Fed cut because the markets tumbled on August 14th with the news of the inverted yield curve.

Should we be worried? Well it’s definitely a red flag. But unemployment numbers have looked good, GDP growth in the United States has been steady and consumer spending spending has been consistent. Maybe its a bit too early to jump the gun and call for doom and gloom.

We also believe the stock sell-off that was witnessed immediately after announcement of the inversion is premature to say the least. An inversion does not imply that markets will fall in the next few months. The same companies that had solid Q2 data don’t warrant being punished overnight in this way. Something else that you should keep an eye out for is how long this inversion lasts.

Regardless of what the inversion of the curve eventually leads to, as we saw with the reactionary price movement of Bitcoin to the tweets on tariff’s, investors clearly have found alternative investment vehicles that they can use for

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References

https://www.investopedia.com/terms/y/yieldcurve.asp

https://www.cbsnews.com/news/inverted-yield-curve-recession-worries-the-yield-curve-inverted-in-a-classic-recession-signal

https://www.marketwatch.com/story/5-things-investors-need-to-know-about-an-inverted-yield-curve-2019-08-14

https://www.cnbc.com/2019/08/14/the-inverted-yield-curve-explained-and-what-it-means-for-your-money.html