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During the midweek session, the equity markets suffered their worst collapse of this year. In particular, the Dow Jones Industrial Average shed 800 points, striking fear among investors. But what has especially worried economists is the inversion of the yield curve. Just what does that mean and why is this metric so critical?

First, a caveat: an article of this format is nowhere near enough to be considered comprehensive, especially concerning a convoluted subject like the yield curve. That said, I’d like to filter out much of the extraneous details and get to the heart of the matter.

And that involves the reason why investors choose assets like government bonds. Typically, these assets are safe havens. When circumstances are volatile – like they are now – government bonds provide stability. They also offer passive income in the form of a yield.

Now the yield curve represents the relationship between time (maturity of the bond) and the yield (payout). A normal curve extends upward and to the right: the more time to maturity, the greater the yield or payout. That makes sense because of the normal risk-reward relationship: the longer you hold an investment, the more risk you assume. To compensate, these longer-maturing bonds offer greater yields.

So what happens when the yield curve inverts? Graphically, the curve extends downward and to the right. That is, bonds with shorter maturity offer greater payouts.

 

Inverted Yield Curve a Nonsensical Reality

If you think the above circumstance doesn’t make sense, you’re absolutely right. Essentially, an inverted yield curve means that investors can receive higher yields for less risk. This dynamic incentivizes shorter-maturity bonds over longer ones, such as 10-year Treasuries.

More critically, this situation represents no confidence in the American financial system. Investors don’t want to tie up their money for 10 years. Therefore, they’re dumping those bonds at whatever price the market will currently support. This selling pressure drives the 10-year yields below the payouts of shorter-term bonds.

Thus, it’s not that we’re living in an economic Twilight Zone. Instead, investors simply lack confidence in the government’s ability to sustain a minimum economic standard. Simply, the resultant selling pressure creates this unusual inversion of normal expectations.

But what’s important here is how the Federal Reserve will respond. Given the panic in the equity markets, the Fed will almost surely drive the shorter-term yields lower. These shorter-term yields are close to the Fed’s fund rate. The central bank will do this to flatten the yield curve, hopefully driving it to normalcy.

Will they accomplish this gargantuan task? Probably not. Unlike other financial problems, this one appears to stem from genuine investor fears. Under such a panicked environment, it’s unlikely that any banking tricks will bring calm.

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