Magazine article Modern Trader

How to Benefit from an Inverted Yield Curve

Magazine article Modern Trader

How to Benefit from an Inverted Yield Curve

Article excerpt

The end of the year 2005 rally was affected after the two-year Treasury note yielded more than the 10-year Treasury note for the first time in five years. Some investors interpret an inverted curve as an indication that the economy will soon experience a slowdown, which causes future interest rates to give even lower yields. Before a slowdown, it is better to lock money into long-term investments at present prevailing yields because future yields will be even lower.

These yield curve inversions are rare, and they form during extraordinary market conditions wherein the expectations of investors are completely the inverse of those demonstrated by the normal yield curve. In such abnormal market environments, bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities. The inverted yield curve indicates the market currently expects interest rates to decline as time moves further into the future, which in turn means the market expects yields of long-term bonds to decline. Remember that as interest rates decrease, bond prices increase and yields decline.

That the inversion has been somewhat limited does not disqualify its importance. Even though yields between the two year and 10-year have moved back and forth in positive and negative territory, the fact remains that it has inverted.

Previous yield curve inversions took place in 1998 and then again in 2000, just before two economic downturns, but note also that the 1996 inversion was followed by an economic boom, so it does not always work! No less an expert than outgoing Federal Reserve Board Chairman Alan Greenspan has discounted the connection between a yield curve inversion and recession. While Greenspan acknowledges that the connection has existed in the past, he has noted growing economic complexity has altered that connection.

Therefore, if it's hard to predict the future of the economy, it is easier to understand that the immediate consequence is a negative for banks, as they can not conduct their carry trade as a profit: borrow short, lend long-term and capture the spread. …

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