Worried About the Inverted Yield Curve?
The yield curve refers to the interest rates on bonds of varying maturity. Normally, we expect the yield on bonds with longer maturities to have a higher yield than those of shorter High Yields maturity bonds. Because it is less of a burden to tie up one’s money for three months or a year, rather than five years or ten years, investors must be given an incentive to place their funds in bonds of longer maturity. This incentive takes the form of a higher interest rate paid on bonds with longer duration. Similarly, we can justify the higher yields on longer maturity bonds based on risk: the foreseeable risk to the economy over the next three-months or year is much less than the risk over five or ten years. Thus the higher yield on long-dated bonds is required to compensate for the added risk of holding an investment that long.
On December 30, 2005, many newspapers heralded the fact that the yield curve on U.S. government bonds had become inverted. In fact, the curve was not consistently inverted. The yield on two-year Treasury notes (just under 4.4%) barely exceeded the yield on ten-year Treasury notes (4.39%). Ordinarily, this type of yield structure will be a self-correcting problems. Investors will no longer choose ten-year bonds, when they can get the same interest rate or even a higher one on two-year bonds. With fewer people wanting to hold ten-year bonds, the interest rates will rise on these in order to clear the market and induce investors to hold ten-year bonds once again.
But when long-term interest rates rise, so too do rates on 15-year and 30-year residential mortgages. If the costs of obtaining a mortgage loan rise, then fewer people will want to buy houses. The result could be either a cooling of the previously hot real estate market, or a potential collapse of some regional price bubbles on real estate.
If inverted yield curves were merely a transitory phenomenon with little or no economic impact, except for people in the business of trading interest rate derivatives, swaps, and bonds; then no one would worry. However, inverted yield curves have often signaled a recession will follow, and the potential for a recession is a legitimate cause for worry.