What causes treasury yields to invert?


Or asked another way; why is demand greater for long duration bonds vs. short?

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The general rule in finance is that more risk demands more reward. This manifests in a lot of different ways, but the way that matters for our discussion is tying up your money in an instrument is riskier the longer that instrument lasts. This makes sense, as if your money is tied up, you won’t get to use it on potentially lucrative investments that come along during the duration – you demand a higher interest rate for foregoing all of that opportunity.

This means that a normal yield curve sees interest rates go up the longer duration the investment is. A 3-year bond will have a lower interest rate than a 5-year, which will have a lower interest rate than a 10-year, and so on.

When you see an _inverted_ yield curve, that means that investors are afraid that there _won’t_ be lucrative investment opportunities in the future – when their investment matures in X years, the opportunities to reinvest will be few and far between. They are willing to accept lower interest rates _today_ because they are guaranteed that return for the duration.

A fear that there will not be good investments in the future is one _potential_ indicator that a recession in on the way. I stress potential, as an IYC is not proof positive that a recession is coming – it just means that bankers think that one _might_ be coming. There is an old joke in finance that the IYC as correctly predicted seven of the last four recessions.

Demand is greater for long duration bonds than short duration bonds because they offer a higher yield. Long duration bonds have more risk associated with them, so investors are rewarded with higher interest rates. This makes them more attractive to investors looking for higher returns.

Demand for long duration bonds is typically greater than for short duration bonds because they offer a higher yield. Long duration bonds are typically riskier than short duration bonds, so investors are willing to accept a higher yield in exchange for the additional risk. Additionally, long duration bonds tend to be less sensitive to changes in interest rates, so they can be a good option for investors looking for stability in their portfolio.

The core deal with treasury bonds is simple. You give the government a lot of your money now, the government gives you back a little money at regular intervals over some period of time. Unless the government defaults (which is considered unlikely), I’m guaranteed that money. They’ll give back the money I gave them at the end, but only at the end – if I want to pull out early, I have to find someone else to buy the bond off of me.

So, let’s compare the ten year bond to a two year bond. Why would anyone ever lock their money away for ten years, when they can lock it away for two? After all, things might go up and you might have better options in two years! Generally, to compensate for the loss of flexibility, the longer bonds are worth more. Investing a thousand dollars in the 2Y bond might pay 40 per year, while investing a thousand dollars in the 10Y bond might pay 50 per year. The ratio of money earned to money invested is called the yield – so the 2Y has a yield of 4%, and the 10Y has a yield of 5%. In this case, the longer bond has the higher yield – a standard curve.

But what happens when I’m certain that the economy is going to go down? Remember, that 10Y bond guarantees its payment for all ten years, while the 2Y bond only guarantees it for two. What do I do if I think I’ll only be able to get 1-2% return per year on my investments two years from now? Well, if I lock my money up in a 10-year bond, I lock in that 5% per year return!

Here’s the catch though: The price of bonds isn’t fixed. Most of the time, people don’t buy bonds directly from the government – they buy them from the open market. From people who own bonds and are willing to sell them. If a lot of people want to buy a particular bond, the price goes up. Suddenly, that bond that pays 50 per year costs me 1100 to buy, not 1000 – so it only has a yield of 4.5%. Maybe the price keeps going up and up as more people try to lock in their investments. This is what leads to the yield curve inverting.

An inversion of the yield curve represents a large number of investors all betting that the economy will go down in a couple of years. It represents investors saying that “guaranteeing a 3.5% return every year for the next 10 years” is more desirable than “having a 4.25% return for the next two years then seeing what’s out there”.

What causes yield curves to invert? Investors thinking that the economy is about to take a nosedive. Why does it matter? Because investors tend to be right more often than not. Let’s look at the yield curve between 10 and 2 year bonds – one that’s particularly reliable and easy to study. [Here’s](https://fred.stlouisfed.org/series/T10Y2Y) the graph. The yield curve inverted in 1978 and stayed inverted for much of the following years… During the two recessions of the early 80s. It inverted in 1989, which was followed by the early 90s recession. It spent the majority of 2000 inverted, right in time for the dot-com bubble to burst in 2001. It inverted in 2006 and 2007, which was followed by the GFC. It even briefly inverted in August 2019, although the ensuing recession was unforeseeable. The yield curve inversions didn’t cause the recessions, but they sure did predict them.