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A primer on 'Inverted Yield Curves', why everybody's going crazy over it and what you should do (1/n)
When Economists refer to the 'Yield Curve', they usually refer to the curve that tracks the returns on the Government Bonds in a country. (2/n)
Government Bonds offer smaller returns for nearer maturities and higher returns for longer maturities. The higher interest is to compensate for the risk taken by the investors by parting with money for a longer term. What's near and long term? Say 1-3 years Vs 10+ years. (3/n)
So if you were to place Government Bonds maturing 1-10 years all next to each other, their returns (Or in Bond terms, "Yield") should form an curve that slopes upwards and eventually flattens out for maturities beyond 10+ years. This is the 'Normal Yield Curve'. (4/n)
For instance, here's India's Yield Curve. We see an upward sloping curve that eventually flattens out. The 1-3 year returns are in the 5.5%-6% range and the 10 year returns are in the 6.5%-7% range. This is a good example of a 'Normal Yield Curve'. (5/n)
In contrast, the Yield Curves of the UK and the USA are visibly different. The Bonds with near maturities (i.e. 1-3Y) offer HIGHER returns than the ones with longer term maturities (i.e. 10Y). This is the infamous downward sloping Yield Curve (or) an "Inverted Yield Curve'. (6/n)
So what's the implication? For one, it implies that investors in the UK and the USA are SELLING short term Bonds to BUY long term Bonds aggressively. Put another way, they're ready to accept a lesser interest for taking more risk by parting with money for a long term. (7/n)
Another easier way to look at it is, when there's more perceived risk, more reward is claimed. Since in Inverted Yield Curves, the short term offers more reward, it implies that investors believe that the economy in the short term is riskier than the long term. (8/n)
There's empirical evidence that Inverted Yield Curves are followed by recessions (Usually with a time lag going up to 1.5-2 years). But that's only a correlation, not causation. Do Inverted Yield Curves CAUSE a recession? (9/n)
In THEORY, since there's a lack of investments in the short term, there's a lack of money flow in the short term. This creates the dangerous spiral of lesser lending, lesser jobs, lesser spending, lesser prices, lesser production and eventually a recession. (10/n)
But if we understand this, Central Banks around the world know it too. That's where the trick lies. An Inverted Yield Curve is certainly a negative indicator for the economy, but it also springs Central Banks into stimulus inducing measures to ultimately avert a recession. (11/n)
Not all Inverted Yield Curves cause a recession. But most recessions cause an Inverted Yield Curve. Also some weaker inversions tend to correct themselves. All those reports about Inverted Yield Curves perfectly predicting recessions? Survivorship Bias. (12/n)
Don't sorry about Inverted Yield Curves. It's not worth your time. If predicting recessions were that easy, we should have dozens of Billionaires who got rich by Shorting the economy the moment they spotted an Inverted Yield Curve. (13/n)
An Inverted Yield Curve is like a Boogeyman story. It's supposed to scare the audience (Policy Makers, Investors) into action (Preventing a Recession scare). But the story itself should not lead them into unshakable faith in the Boogeyman is real. That's just plain crazy. (14/n)
Here's a short article from Forbes that neatly covers the 'Inverted Yield Curve' Boogeyman story. (15/n)

Here's a more detailed, data-heavy case by @AswathDamodaran

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