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
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.
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