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How do yield curves indicate a recession?

I was watching a US business program and the expert being interviewed said he was confident that the stock market would keep rising because the yield curve was not inverted and that history shows that a recession usually results when the yield curve is inverted. Could you explain what the yield curve is? What an inverted one means? And what is the link to recession?

An inverted yield curve is when the yields or interest rates on short-term Treasury notes or government bonds are higher than long-term yields or interest rates on these bonds. You can see that a yield can be a proxy for the effective interest rates.

Bonds come with a coupon interest rate and these are the rates actually on the bond when issued.

For example, say a $100,000 bond promises to pay 10 per cent or $10,000 a year. Now, if interest rates for newly issued 10-year bonds falls to five per cent, then the old bond is much more valuable if the current holder wants to sell it. The rule is if interest rates fall then bond prices rise.

The yield curve has interest rates on the vertical axis and time along the horizontal axis and so if short-term interest rates are high compared to long-term, say 10-year bonds, then the yield curve is inverted – high in the beginning and sloping down to the right. This means that investors prefer to purchase 10-year bonds, at a lower yield, than one-year Treasury bonds.

These investors believe they will make more by holding onto the longer-term bond than if they kept buying and reinvesting in short-term bonds which will return much less in the near future.

When would that happen? Well, that’s when a recession comes in. When an economy hits a terrible economic downturn, interest rates are slashed in the short-term and those who piled into long-term bonds when they were lower than short-term bonds would now be laughing.

For this reason, an inverted yield curve usually means the economy is headed for a recession, as it did before the US recessions of 2000, 1991 and 1981. Right now, the yield curve is not inverted but we’re in a very special economic cycle where we have avoided a serious and possible economic depression, so confidence in economic rules of thumb, which often work out, do have a fair few doubters at the moment.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Published on: Friday, June 25, 2010

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