Unusual trend of Yield Curves
Yield curves have historically been used to infer about the economic and financial strength of an economy. It is said that Government and Treasury use yield curves to predict coming recession 3-4 quarter in advance.
Yield curves are normally upward sloping at a diminishing rate. There are two common explanations for upward sloping yield curves. First, it may be that the market is anticipating a rise in the risk-free rate. If investors hold off investing now, they may receive a better rate in the future. Therefore, under the arbitrage pricing theory, investors who are willing to lock their money in now need to be compensated for the anticipated rise in rates—thus the higher interest rate on long-term investments.
However, interest rates can fall just as they can rise. Another explanation is that longer maturities entail greater risks for the investor (i.e. the lender). A risk premium is needed by the market, since at longer durations there is more uncertainty and a greater chance of catastrophic events that impact the investment. This explanation depends on the notion that the economy faces more uncertainties in the distant future than in the near term. This effect is referred to as the liquidity spread. If the market expects more volatility in the future, even if interest rates are anticipated to decline, the increase in the risk premium can influence the spread and cause an increasing yield.
There are few thoughts that pop up into my mind when I look at this Yield Chart.
Are we heading for recession, the dreaded double dip? Strongly inverted yield curves have historically preceded economic depressions. After looking at charts, it seems formation of inverted curves have already started. Short Yields are close to historical lows in anticipation of deflation. If it starts to flatten out from here then we will see inverted curves.
Long 30-Year Yield has been flat since few months whereas 10-Year, 5-Year and 2-Year Yields have fallen substantially. This shows uncertainty which investors see in long run with US economy and want more reward for more risk. Another reason being the fear of inflation which could grip US because of austerity measures during recession.
Will 30-Year bond finally catch up with others and show a downward movement? That should happen if we are moving into recession. In fact 30- Year Yield curve held up could mean investors see that double dip recession is avoidable.
This is not the end. If economic condition starts to improve then we may expect short run curve to retreat with rise in interest rates but that seems too farfetched currently. Question is where do we go from here???