Inverted Yield Curve: Most Reliable Recession Predictor Now Flashing RED
WHAT IS YIELD CURVE INVERSION?
The US government (as indeed governments around the world) issue bonds, and anyone who invests in these bonds essentially ends up giving a loan to the US government. The US government in turn pays an interest to those who invest in these bonds. US government bonds are of various durations – there are bonds of duration as short as 3 months, and there are bonds of as long as 10, even 30 years. When you invest in a 3 month bond, you are essentially giving a loan to the US government for 3 months; if you are investing in a 10 year bond, you are giving a loan for 10 years – as simple as that. Now in any loan, the amount of risk that the lender incurs keeps on increasing with the duration of the loan. If you loan someone money for 1 year versus 10 years, the risk that the borrower may not be able to return your money is higher in case of the 10 year loan because risks such as the borrower not being in good health, or the borrower losing his/her job and hence not being able to service his/her loans are significantly higher over a 10 year period than in the next 1 year. Hence lenders always insist on a higher rate of interest on longer duration loans than on shorter duration ones to compensate for the higher risks.
The same logic applies to government bonds as well, since a government bond after all is nothing but a loan extended to the government, and therefore, the interest payable on a 10-year bond is ordinarily higher than the interest payable on a 3-month bond. However, there have also been “abnormal” times when this principle goes for a toss and yield on 10-year government bond drops below that of 3-month government bond. And when this happens, the bond market is said to be in “Yield Curve Inversion”. And historically, whenever the yield curve inverts, bad things typically follows – both for the economy as well as for equity markets, NOT just in the US, but also for most emerging markets, including India.
IMPACT OF PAST INVERTED YIELD CURVE ON NIFTY?
When the inversion happened for the first time in this century in July 2000, the NIFTY was already in the early stages of a 51% correction (we refer to that correction today as the “dot com bubble burst”). The next time the inverted yield curve (in July 2006), a 60% correction in the NIFTY followed 18 months later. We got the third inversion of this century in May 2019, only to be followed by a 38% correction in the NIFTY between Feb and March of 2020! The yield curve for the fourth time in this century in Oct 2022, and the scale of the inversion this time has been the highest in recorded history!
To be sure, the yield curve has also delivered false alarms twice in history (1966 and 1998) i.e. there was no recession despite the yield curve inverting. So what’s in store this time? Are we headed into a nasty recession once again? Or will this latest inversion end up becoming the third false alarm in history? We will have to wait and see, but the odds are clearly stacked in favor of yield curve inversion paving the way for a recession, more so given the scale of inversion this time round!
Watch the full YouTube video below on the inverted yield curve
