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.”
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