The stock marked plummeted on Tuesday with Nasdaq down near 4 percent. This is scary for many investors around the world. More scary is a quick look at the 2-year note that dropped more than 26 percent.
The wide spread between the 2-year note and the 10-year note is around 10 basis points which is the flattest since 2007. Bond prices move in the opposite direction of yields, and the spread between the 3-year note and the 5-year note have already inverted. 1-year note and 10-year isn`t near at all.
In a normal situation, the short-term bills yields less than the long-term bills, which means that investors expect a lower return when their money is tied up for a shorter period like 1,2 or 3-year notes. Investors require a higher yield to give them more return on a long-term investment.
If investors have little confidence in the near-term economy, the yield curve inverts. Investors demand more yield for a short-term investment than for a long-term one. They belive the near-term as riskier than the long-term.
In a situation like that, investors would prefer to buy long-term bonds and tie up their money for years in the long run even though they receive lower yields. The reason why investors do that is because they believe the economy is getting worse in the near-term.
An inverted yield curve is most worrying when it occurs with Treasury yields and that`s when yields on short-term Treasury bills, notes and bonds are higher than long-term yields. During healthy economic growth, the yield on a 30-year bond will be three pints higher than the yield on a three-month bill.
The reason why the short-term bill decline and makes an inverted yield curve is that investors believe they will make more by holding onto a longer-term bill than a short one. They think they need to reinvest in a short-term bill a few months any way.
If investors think that the economy is slowing and the recession is coming, they expect the value of the short-term bills to plunge in a short period of time. When the economy slows down, the FED lowers the Fed funds rate, and the short-term Treasury bill yields track the fed funds rate.
It is when the demand for long-term bills goes up that the demand for the short-terms bills goes down. Then the yield for short-terms bills goes up while the yield for the long-term bills goes down, and that`s whats happening now.
For example,when the yield on short-term Treasury’s rises higher than the yield on long-term bonds is where the yield curve inverts. The Treasury yield curve inverted for the first time since the recession. The 3-year note was higher than the 5-year note. Investors are saying that the economy is better in five years than in three years.
President Trump is disappointed when it comes to the FED`s descision to raise the rates which is going to raise to about 3,5 percent in 2020. Mr Trump and investors are worried it could trigger an economic slowdown in three years if the rates is too high.
This small inversion is probably temporary, but if it continues to grow bigger, we can be thrown into a recession. The current fed funds rate determines the outlook of the U.S economy, and people should never ignore an inverted yield curve. Just take a look at the history.
In June 2007, the yield curve was on the brink and went back and forth, between inverted and flat yield curve. The Fed reacted too late and lowered the fed funds rate ten times until it reached zero by the end of 2008.
The yield curve was no longer inverted but it was too late, and we know the rest of the story; The economy went into the worst recession since the Great Depression. This is just a reminder.
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