Why Does The US Yield Curve Inversion Matter?

US equity markets have been struggling the past few days, with a variety of reasons being offered up: Brexit; the US-China trade war; and the Federal Reserve’s rate hike path, among others. But a new explanation has appeared in recent days, one that has yet to make an appearance in 2018, or really at any point in the past decade: the inversion of the US Treasury yield curve.

WHY DO INVESTORS LOOK AT THE YIELD CURVE?

The yield curve, if it’s based on AA-rated corporate bonds, German Bunds, or US Treasuries, is a reflection of the relationship between risk and time for debt at various maturities. A “normal” yield curve is one in which shorter-term debt instruments have a lower yield than longer-term debt instruments. Why? Put simply, it’s more difficult to predict events the further out into the future you go; investors need to be compensated for this additional risk with higher yields. This relationship produces a positive sloping yield curve.

When looking at a government bond yield curve (like Bunds or Treasuries), various assessments about the state of the economy can be made at any point in time. Are short-end rates rising rapidly? This could mean that the Fed is signaling a rate hike is coming soon. Or, that there are funding concerns for the federal government. Have long-end rates dropped sharply? This could mean that growth expectations are falling. Or, it could mean that sovereign credit risk is receding. Context obviously matters.

DOES THE US TREASURY YIELD CURVE INVERSION MATTER?

It’s true that part of the US Treasury yield curve started to invert this week. We’ve seen both 2- and 3-year yields rise above 5-year yields. The “flattening” of the yield curve over the past year, predating this week’s inversion, is rather apparent when comparing the shape of the yield curve today relative to that from last December:

US Treasury Yield Curve (December 6, 2018) (Table 1)

(Click on image to enlarge)

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