Understanding the Inverted Yield Curve

There’s been a few comments intimating that, well, maybe an Inverted Yield Curve ain’t so bad. I have to disagree in the strongest possible terms. And I have three decidely non-textbook reasons as to why:  Cyclical, Liquidity, and Predictive factors.

Cyclical Factors: At the end of a recession, the Fed will have
already been cutting short rates. The curve will be rather steep at that
point in the business cycle — and not coincidentally, its when and where an expansion is most likely to occur.

Conversely, when the curve inverts, its at the
opposite end of the wheel — when the economy has been heated up for a while, after an expansion, after a round of Fed tightening.

Liquidity: A steep yield curve is stimulative. Its because there’s so little return for investors at low rates — by cutting rates, the Fed essentially encourages any investment alternatives to bonds. Capital holders (investors) look to put their cash to work elsewhere; That capital investment tends to be broadly stimulative.

Predictive Bond Market:  Regardless of what factors contribute to the yield curve inverting, it
is essentially a collective expectation by the Bond Market that even
LOWER RATES ARE IMMINENT — in other words, lock in rates NOW while you
can.

Why else would investors take a LOWER INTEREST RATE ON LONGER TERM LOANS THAN SHORTER TERM? You tie cash up for longer, there is lengthened risk, plus the opportunity costs — the loss of the use of that capital for other potentially lucrative investments.

Why might rates get worse? Its the expectation by very smart money of a WORSENING ECONOMY and all that entails.

Its essentially an economic bet — that this is the last chance to lock in mediocre rates before they get much worse. Someone else described (cant remember who) as "A chance to lock in rates before the bottom falls out."

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If you would like to see specific examples of yield curves from varying years and how they played out there’s an excellent primer at Smart Money that’s well worth reading:  The Living Yield Curve

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