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How does a yield curve invert?

Hello All,

One of the topics that has come up in the past week is the big yield curve inversion that freaked everyone out. My question is:

What causes the yield curve to invert?

I understand the yields drop because more investors are buying into the longer-dated bonds, pushing the yields down. But I would think that the $ volume of such transactions would have to be immense across the investment world and investors to actually cause it to invert so suddenly. So how does that happen? Is it just one big AM, such as Blackrock, making a move which is followed by other investors watching the big players and following suit? 

How is the decision to go long made at some of these AMs? Is it a top-down decision or is it more so traders moving their book which causes the yield curve change?

Let me know if any of my points above is unclear.

Thanks.

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if you were the federal reserve you can easily invert the curve just by raisng short term rates

long term rates falling is more due to fear of deflation, flight to safety.

I love my cheese. I got to have my cheddar.

Why assume that an upward sloping yield curve is normal? Are you saying you always expect rates to increase?

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rates definitely have a long term trend, but they typically have a normal rate of 5% for a 5 yr.

upward sloping yield curve is normal because it is the case 95% of the time. yield curves are rare occurence, and even when they occur, they quickly revert to an upward sloping yield curve. this is known.

I love my cheese. I got to have my cheddar.

Term premium has generally been positive, but why does it need to keep being positive? This premium has been decreasing for the past 20 years - perhaps reborrowing risk and market segmentation relationships are changing over time.

If term premium goes to zero, the yield curve will invert about 50% of the time. Clearly, an upward sloping yield curve has not historically indicated future rates expectations. Otherwise, rates would be like 10000% now. 

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negative term premium would break the corporate bond market though no?

i get how its possible for investors to at one point see the advantage of locking into a longer guarantee of their capital with a sovereign and paying a premium for that guarantee but you would never do that with a corporate… the longer you are exposed to corporate risk, the higher the risk of loss. pretty sure a negative yield curve long-term would mean equities need to price in like 50 years of 1% deflation and fall 90%… i’m not going to say its impossible but it makes my head hurt a bit.

also, thought i would note that general mills issued a 10-month euro bill yesterday at 0%. who is accepting this credit risk for 0% yield? why not just hold cash? and these are good times apparently…

Inverted swap rates and treasury rates doesn’t have to mean inverted corporate bond yields, since credit spreads have their own term structure. 

But in any case, if government bond yields (or whatever is considered most “risk free”) become steeply inverted, inverted corporate yields can still be considered a relatively good value, especially if you believe yields will be even lower in the future. 

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ohai wrote:

Term premium has generally been positive, but why does it need to keep being positive? This premium has been decreasing for the past 20 years - perhaps reborrowing risk and market segmentation relationships are changing over time.

If term premium goes to zero, the yield curve will invert about 50% of the time. Clearly, an upward sloping yield curve has not historically indicated future rates expectations. Otherwise, rates would be like 10000% now. 

it should be positive as a rational investor would always demand to be compensated for having to hold duration risk and general uncertainty over a longer period.  An inverted yeld curve implies that short term rates now are higher than what the market expects in the future.  

A yield curve is not linear over time as you’re saying.  30 years ago the 30 year rate was not the rate we see today on the short end.

“as a rational investor would always demand to be compensated for having to hold duration risk and general uncertainty over a longer period.”

No, this is only one possible scenario. What if some entity is issuing bonds yielding 3% for 1y and 2.9% for 3y, but you believe that the interest rate might go down to 2% soon? You would be rational to buy the 3y bonds, even at a lower yield than 1y, as you would lock in a high interest rate for a longer duration.

“A yield curve is not linear over time as you’re saying.  30 years ago the 30 year rate was not the rate we see today on the short end.”

I did not say this or make this implication. I only said that yield curves carry expectations of future rates. 

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all a yield curve does is measure how many pussies are in the market. 

I love my cheese. I got to have my cheddar.

i get where you’re coming at from the corporate curve standpoint. but you are positing a mostly permanent inverted yield curve for treasuries. when the front end of the curve starts at 2.4% now, and could easily be down to 0% at some point, a prolonged inverted yield curve with this starting point would basically spell the end of the world imo. basically every bank and financial institution would be bankrupt given their leverage and funding models.

Upward sloping yield curves make sense from a risk/return perspective.

If you’re buying a 2 year bond at 2%, you’re effectively making a bet that you won’t be able to do much better than that (rates-wise) for 2 years.

If you’re buying a 30 year bond at 2%, you’re doing the same thing, but the risk that rates get higher than that over a 30 year period is substantially more. Which is why investors SHOULD demand higher rates on longer term bonds. And thus, this is why yield curves are upward sloping the majority of the time.

However, when the yield curve inverts, it signals that LT investors are calling bullsh*t on the current environment and as stated above, is an early ‘flight to safety’ signal. And if you ask me, the bond market is right more often and earlier than the stock market.

Right now you’re getting 2.44% for 6 month paper and 2.88% for 30 year paper. I’m not taking buckets of duration risk for 44bps. F that.

ohai wrote:

“as a rational investor would always demand to be compensated for having to hold duration risk and general uncertainty over a longer period.

No, this is only one possible scenario. What if some entity is issuing bonds yielding 3% for 1y and 2.9% for 3y, but you believe that the interest rate might go down to 2% soon? You would be rational to buy the 3y bonds, even at a lower yield than 1y, as you would lock in a high interest rate for a longer duration.

I bolded the part you missed.  It’s a generalization of investor behavior over a longer period which is why yield curves tend to be upward sloping.

To your example, if my 1-year bond that yields 2.9% rallies to 2.45% because interest rates fell, as expected, have you made more or less than holding the 3-year bond at 2.9% for 3 years?  

ohai wrote:

“A yield curve is not linear over time as you’re saying.  30 years ago the 30 year rate was not the rate we see today on the short end.”

I did not say this or make this implication. I only said that yield curves carry expectations of future rates. 

Not sure what you are trying to say then. 

4 week t Bill is better than my hy savings account 

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to all the naysayers who are saying the yield curve needs to invert a certain way and to a certain depth are missing the fact that LT inflation expectations are basically anchored at 2% unless there is a broad consensus of recession. the only way to unanchor LT inflation at 2% is to basically agree as a group that the Fed has no control over inflation over the long-term, mostly due to an impending recession expectation and deflation.

as a result, the degree by which the 10-year or whatever can invert is extremely limited, especially when compared to other yields with term like the 2 yr or higher. with the fed funds rate anchored at 2.4% for now, the fact that years 2-7 are currently inverted and the 10 inverted recently is fairly telling from a historical point of view.

inflation and growth, which is the mother of all financial, debt and equity markets. 

Ditto with Matt Like Analysis

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