The inversion of the U.S. Treasury yield curve usually refers to the difference between the yields of 10- and 2-year Treasuries. The standard pattern in the debt market implies that the longer the duration (i.e. time to maturity), the higher the yield due to higher risks.
That is why the yield curve is directed upward with respect to duration. But sometimes the opposite happens, and the curve flattens out first and can flip over afterwards.
Why does this happen?
The yield on government bonds is determined by supply and demand on the debt market. The higher the demand, the higher the price and therefore the lower the effective yield, and vice versa. When the demand for ten-year notes rises sharply, the price rises and the curve becomes inverted. This usually happens when investors are very worried about the economy. They start seeking refuge in long-term bonds, pulling capital out of the stock market, and the latter falls.
What does this mean?
Back in the 1980s, Cam Harvey in his research first linked the appearance of an inversion to the occurrence of a recession in the economy. Since then, absolutely every economic downturn has been preceded by a yield curve inversion. That includes 2001-2002 and 2008-2009, as you can see in the graph. One of the main reasons is the sharp slowdown in lending. Banks are using short-term borrowing to finance long-term loans. The rate on the latter tends to be higher, and they make money on this spread. Logically, when the pattern breaks, economic activity begins to decline.
What is it now?
As you can see, the inversion has reached a record high since the crisis of the ’80s. But this time, the conditions are a little different. The Fed is actively intervening in the debt market through QE/QT, and it didn’t start doing that until after 2008. And it has a very strong effect on liquidity. That is, previous inversions were of a natural nature, and this one may be partly artificial and therefore so strong. Does this mean a recession is coming? Most likely, yes. But for now, this is not a reason to liquidate the portfolio and go completely into cash. Usually the time lag before the economy actually enters the downside phase is 6-18 months (this time the inversion started in June), and the recession starts after the yield curve recovers. Translated with www.DeepL.com/Translator (free version)
