What is a Yield Curve Inversion?
SUMMARY KEYWORDS
Treasury, 10-year treasury, 3-month treasury yield curve inversion, yield curve, rates, interest rates, recession, bonds, higher interest rate, federal reserve
00:00
Hi, it's Katherine at Sunnybranch Wealth, and in this video I'm going to be walking you through the yield curve inversion that happened earlier this week. We're going to be talking about what a yield curve is, why it matters that it's inverted, and what it might mean for the future. So, first, we're going to talk more generally about what yield curves are. When we talk about yield curve inversions. We're talking about US Treasuries, which are bonds issued by the US government. And treasuries come in a variety of different lengths. So, you can have three-month treasuries, you can have 10 year treasuries, you can have treasuries that are 20 years or longer. And in the case of this specific inversion, we're looking at two specific lengths of US Treasuries, we're looking at the 10-year Treasury, and we're looking at the three-month treasury. Before we dive into the specifics of the yield curve, and the inversion, we're going to talk much more generally about treasuries, interest rates, and what the relationships are there.
01:18
The first thing we're going to talk about is the inverse relationship between the price that you pay for a Treasury and the yield, or the interest rate, that Treasury pays. You can think of this as a pretty basic function of supply and demand. For example, if the 10 year treasury, if no one wants it for a variety of reasons, we're going to touch on some of those reasons in a minute. But if there's a lack of interest in buying 10-year treasuries, that means that the price of those Treasuries are going to fall. And in order to entice people to buy the treasuries, the government is going to have to offer a higher interest rate on that Treasury. This is really important to remember, and this is true for all bonds, there is an inverse relationship between the price of the bond and the yield that that bond pays.
02:14
The other important thing to remember about bonds is that generally, when you buy a longer duration treasury, you're going to be compensated at with a higher rate. And you can think of this because of the inherent risk that you're taking on by loaning your money to the government for a longer period of time. So, say that I loan you money for 10 years, and you're paying me interest, I'm going to want a higher interest rate over that 10-year period, because there's more inherent risk to me. Because what if interest rates changed during that period in a way that's not in my favor? What if I need that money? And now imagine that instead I'm loaning you money for three months. I'm not particularly concerned, or at least as worried, about the risk to me because the period is so much shorter. The two things to keep in mind are: (1) that there is an inverse relationship between the price of the bond and the yield that that bond pays. And (2) generally speaking, when you buy a longer duration bond, you are going to be compensated, but with a higher yield or interest rate.
03:31
What we're talking about in the case of this specific inversion is the rate that is paid when you purchase a 10-year Treasury, and the rate that is paid when you purchase a three-month treasury. And if you think about what I was just saying, you would expect that you would receive a higher rate if you buy a 10-year treasury, right, because it's for a longer duration. And generally, that relationship holds true. If you look at a chart that shows the spread, or the difference between the rate of a 10 year treasury and a three month treasury, generally, the 10 year Treasury is going to pay a higher rate. This is true, except in the case of specific inversions, which is what we saw this week. And that's where you are actually being paid a higher rate to buy a three-month Treasury than you would to buy a 10 month treasury.
04:30
This is a little confusing to understand. But like everything I feel like I've been talking about for the past six plus months, it has to do with the Federal Reserve and interest rates. So, basically, what investors think is going to happen is that in the short term, interest rates are going to rise because the Federal Reserve has signaled it's going to keep interest rates increasing because it wants to get inflation under control. The Fed has to get inflation under control. And so, in the short term, investors think rates are going to rise. They are demanding a higher rate to buy three month treasuries, because they expect rates to increase in the short term future.
05:17
But long term, the markets and investors think that we're probably going to go into a recession. And while the Federal Reserve in the short term is going to have to raise rates, if we look out at the medium term, say over the next six to 15 months, investors think that the Federal Reserve is going to have to start cutting rates, because we're going to enter a period of more sluggish economic growth, where cutting rates is the only option, or one of the best options, that the Federal Reserve has to stimulate growth. What that means is that investors think rates are going to be lower in the longer term, which is increasing demand for 10-year treasuries now. Remember, when demand increases, then the yield decreases. You have an increasing demand for 10 year treasuries, which is driving down the yield. And you have this expectation that rates are going to increase in the short term, which is driving up the yield on three-month treasuries.
06:23
When you put those two things together, it means is that earlier this week, we saw an inversion, where the rate that you were paid for buying a three-month Treasury is higher than the rate that you would be paid for buying a 10-year treasury. In a vacuum, this doesn't mean anything, right. Like you have these two things. There's a relationship that usually exists between the 10-year Treasury and the three month treasury, we saw that that relationship changed, you know, that there was this inversion. And so that historical relationship where the yield on the 10 year is higher, no longer existed. But why do we actually care?
07:05
The reason we care is that if you go back to the 1950s, every time the yield curve for the 10-year Treasury and the three months treasury have inverted, every time except once in 1967, that inversion has been followed in the next six to 15 months by a recession. That doesn't mean that in the next six to 15 months, we will be in a recession. But if you believe in the value of predictive indicators, which are one tool we have in our tool belt, you have to listen to what they're saying, even if you're not a believer, there's a very high likelihood that we will in fact, enter a recession in the next six to 15 months.
07:52
That doesn't mean that we need to do anything today. But it explains why investors and the financial media have been so excited and have really been calling attention to the fact that these yield curves inverted. Again, we don't know what's going to happen in the future. It certainly is a worrying sign and probably increases the likelihood that we're going to be in a recession at some point in 2023. But time will tell. We are going to be living these changes within the next several months and I'll be here keeping you updated. Have a good one.