Eli5: How can the price of a 10 yr T bond be a predictor of recession? What is the relationship between price and rate?

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Eli5: How can the price of a 10 yr T bond be a predictor of recession? What is the relationship between price and rate?

In: 80

Interest rates are determined by risk. The riskier an investment is, the larger the interest rate will need to be before someone will accept it. If I’m unlikely to pay you back, you’ll charge me a high interest rate. If I’m almost guaranteed to pay you back, you’ll demand a lower interest rate.

Now, Treasury bonds come in a couple of different year amounts. You could buy a year, two year, five year, etc. Treasury bond. The longer the term on the bond, the higher interest rate. This reflects the fact that a long-term investment is riskier than a short-term investment. For example, if I got a single day Treasury bond, I’m super confident it’ll be paid back and my interest rate will be low. A 100 year bond would offer a higher interest rate, because I’m less certain it will be paid back.

The price of a 10 year Treasury bond is useful in comparison to other year values. Let’s say we’re looking at a 2 year and a 10 year bond. In a normal world, the 2 year bond will have a lower interest rate than a 10 year. This reflects the larger risk in a 10 year bond.

What happens if the 2 year has the same (or a higher) interest rate than the 10 year? That indicates that confidence isn’t super high in the next two years; if this were normal times, the interest rate should be lower than the 10 year. This is known as an “inverted yield curve.”

Earlier post talks about “risk” when risk really isn’t a factor in T bills. US Treasury bills are about the most risk free investment there is. The US government has never, EVER defaulted on a treasury bill, not a single penny. If investment firms were seriously worried that the US government would default within the next 10 years it wouldn’t cause an interest rate change, it’d cause a global economic *meltdown*.

In fact, the other poster has it wrong. Inverted yield curves aren’t caused by people wanting *fewer* long term bonds. They’re caused by them wanting *more*.

A treasury bill is just you loaning the government money. In an ideal situation, the longer you loan the government money, the more the government “rewards” you by increasing the amount paid back. Generally. This is why *generally* 10 year T bills have a higher interest rate than say..2 year T bills. If you’re willing to loan the government your money for *ten* years, you damn well better get MORE out of it than if you only lend it for 2 years.

But government T bills are sold on an exchange, and interest rates fluctuate based on supply and demand. When people buy more of them, interest rates drop. When they buy less, interest rates rise to be more competitive and attractive.

So when you get an inverted yield curve, what happens is when, typically, a 2 year treasury bond has a higher interest rate than a 10 year bond. This can happen either because:

1) 2 year bonds are in extremely low demand, driving the interest on a 2 year bond UP, or;

2) 10 year bonds are in extremely *high* demand, driving the interest on a 10 year bond *down*.

So why does an inversion yield curve predict recession? Because if people start thinking the economy is going to tank, driving down stock markets, and destroying their long term investment future, they’re going to do the smart move and put their money in the safest place possible to weather that storm.

So when people start thinking “I need to move my money into some place safe because a recession could last a few years” they stick it in a safe place.

And there’s nothing safer than a US government 10 year treasury bill.

And when suddenly people are buying up a whole lot of 10 year treasury bills this drives the interest rate down. Which can create the inversion.

“Price” and “rate” of a loan are essentially the same thing. Take a $100 loan, you’ve got to pay off $105 in a year. That costs you $5, the rate is 5%. But these are bonds, so you’re the one making the loan. You’re loaning the government money, and they pay you back more, later.

If the rate of a US federal treasury bond is high, the government needs money and will raise rates until it sells enough.

10 year T notes typically have a higher rate than 2-year bonds. They’re riskier because they tie up your money longer.

Currently… that’s inverted. Because investment people are getting the hell away from bond (forcing the government to sell them at a higher rate). The short term bond market reacts faster than the 10 year market. Bonds are a nice safe thing to do with money, as long as there’s not inflation or big market changes. But if there’s a crash coming, you want cash on-hand because that’s the time to invest, not locked up in bonds.

Real long story short: **Investors are collectively predicting an economic down-turn and are avoiding buying bonds.**