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Bond yield inversion is a term that you may have heard in the news lately. It refers to a phenomenon in which the yield on longer-term bonds becomes lower than the yield on shorter-term bonds of the same credit quality. This inversion of the yield curve is often seen as a potential signal of an economic recession, which is typically defined as a period of declining economic activity, characterized by a contraction in GDP, increased unemployment, and decreased consumer and business spending. The bond yield inversion suggests that investors are more worried about the short-term outlook for the economy than the long-term outlook, which may indicate that a recession is on the horizon.
Why use the 2-year and 10-year Treasury notes to calculate the bond yield inversion? The answer lies in the fact that these two bonds are considered benchmarks for the US Treasury market. The 2-year note is a short-term bond, while the 10-year note is a longer-term bond. By comparing the yields on these two bonds, we can get a sense of how investors view the relative risks of short-term versus long-term investments.
When the yield curve is sloping upward, with longer-term bonds yielding higher returns to compensate for the risks associated with holding bonds for a longer period of time, the economy is typically expanding. However, when the yield curve inverts, with yields on shorter-term bonds being higher than yields on longer-term bonds, it may indicate that the economy is heading for a recession.
Let's take a look at some historical examples of bond yield inversions and their correlation to recessions:
Carter Administration: In the late 1970s, there was a bond yield inversion between the 2-year and 10-year Treasury notes. In September 1978, the 10-year yield was 8.28%, while the 2-year yield was 8.80%. This inversion was followed by a recession in 1980.
Dot-com Bubble: In 2000, there was a bond yield inversion between the 2-year and 10-year Treasury notes. In December 2000, the 10-year yield was 5.09%, while the 2-year yield was 5.27%. This inversion was followed by a recession that began in March 2001 and lasted until November 2001.
2008 Financial Crisis: In 2006, there was a bond yield inversion between the 2-year and 10-year Treasury notes. In August 2006, the 10-year yield was 4.79%, while the 2-year yield was 4.81%. This inversion was caused by concerns about subprime mortgages and other risky lending practices. The resulting recession began in December 2007 and lasted until June 2009.
2020 Pandemic: In 2019, there was a bond yield inversion between the 2-year and 10-year Treasury notes. In August 2019, the 10-year yield was 1.50%, while the 2-year yield was 1.59%. This inversion was caused by concerns about global economic growth and trade tensions. The pandemic led to a recession that began in February 2020 and lasted until April 2020, making it one of the shortest recessions on record.
As of February 17, 2023, the yield for a 10-year U.S. government bond was 3.82 percent, while the yield for a 2-year bond was 4.6 percent. While bond yield inversion is not a foolproof predictor of a recession, it remains a widely watched indicator among economists and investors. The phenomenon has been seen before many of the most significant economic downturns in recent history, including the 1980 recession, the Dot-com Bubble, the 2008 financial crisis, and the 2020 pandemic recession. The bond yield inversion suggests that investors are more worried about the short-term outlook for the economy than the long-term outlook, which may indicate that a recession is on the horizon. However, it's important to remember that the yield curve is just one of many economic indicators, and other factors can also contribute to economic downturns. Nonetheless, keeping an eye on bond yield inversions can be a useful tool for investors to help them make informed decisions about their portfolios.
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