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Updated 11:50 25/06/19

US yield curve inverts for the first time since 2007 – and we know what happened next…

Liam Sheasby

By Liam Sheasby, News Editor

29 Jun 2018

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The yield curve, which is the difference between interest rates and returns on short-term and long-term government bonds, has inverted in the United States for the first time since 2007. The fear for investors and market experts is that inversions usually predicate a recession (see below) and have consistently served as a warning.

The last major inversions came in February 2000, just before the Dot Com Bubble burst, and again in 2007, just before the Great Recession.

The rate was approaching inversion on Monday and by Wednesday it had passed the mark, making 2-year bonds more advantageous than 10-year bonds. The US Federal Reserve has been promoting 2-year bonds by offering slightly better yields in order to fund its planned infrastructure programme.

Typically, 10-year bonds are more attractive than 2-year bonds because strong economic growth could breed inflation over time, so the government offering them gives sells at a slightly better interest rate, but long-term yields have been decreasing in value and appeal thanks to economic concerns – chiefly the US trade tariffs and the potential trade war they could trigger – making investors cautious of committing to long-term lending. As one goes up and the other goes down it’s inevitable that the curve would flatten. To some it may appear an odd conclusion to suggest recession is coming, especially when the US is reporting near-record low unemployment and investment is on the up, but this artificial boost is a short-term boon.

Somewhat ironically the threat to the US economy is the self-fulfilling prophecy that occurs when yields are allowed to invert. Investors fear the yield inverting. Fear makes them cautious, and their caution is the crux of the recession fear. This psychological impact leads to more interest in short-term bonds at the expense of larger investments. This then causes the yield to invert further, lending becomes less profitable, and so investment funds are withdrawn. With no invested funds the economy slows down and moves towards recession, with public spending, currency devaluation, and a rise in unemployment all symptoms of an economy that is not growing.

Past recessions preceded by a yield curve inversion have taken anywhere between six months and two years, so there’s still time for the Federal Reserve to take action to avoid continued inverted yields and tempt investors back.

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What are bonds/gilds?

Let’s say that Country A wants to invest in a project, like upgrading its internet network. It needs money to achieve this. It could do this with taxes, but they aren’t popular with many people. They could do it with the funds they already have, but then they’d have to cut from another part of the budget.

The alternative? Outside investment. The government needs to persuade the investors to give them their funds, rather than investors putting it into gold bullion or the stock markets.

To persuade them, Country A’s treasury will sell bonds or gilds. These are usually 2-year or 10-year agreements. Under the agreement, investors will pay a lump sum up front and are then guaranteed to receive that money back in portions throughout the time period.

A 10-year bond at £100,000 with a 10% yield would pay £10,000 per year until the decade was over.

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