Dialectical View on Treasury Bond Yield Inversion

What is an inverted yield curve?

It can be broadly divided into two categories: First, long-term interest rates are lower than short-term interest rates; second, the interest rates of those with lower credit ratings are lower than those with higher credit ratings.

A typical example is that the yield on 10-year U.S. Treasury bonds is lower than that on 2-year bonds, and the yield on Japanese government bonds with lower credit ratings is lower than that on U.S. government bonds with higher credit ratings.

Let's set aside the latter for now and focus on the situation where long-term interest rates are lower than short-term interest rates.

Historical experience tells the market that when this happens, the probability of an economic recession will greatly increase.

For example, over the past 26 months, the U.S. has experienced the longest period of inverted Treasury yields in history, where the yield on 10-year Treasury bonds is lower than that on 2-year bonds.

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For the U.S. financial market, these two maturities of Treasury bonds are representative interest rate benchmarks, and the conventional financial explanation for the yield inversion between them is that because the U.S. economic situation is better in the short term than in the more distant future, the interest rates for the more distant future need to be lower than the short-term interest rate levels.

The yield inversion highlights the judgment that the U.S. economy may be in a recession.

Now, there is a turning point in the issue.

On September 4, the yield on 2-year U.S. Treasury bonds fell 9 basis points to 3.7683%, while the yield on 10-year Treasury bonds fell 6 basis points to 3.7684%.

Although the gap is extremely narrow, it has ended the 26-month period of yield inversion.

Is this a good thing?

On the contrary, Wall Street's judgment is that the timing of the "inversion to positive" in U.S. Treasury yields is precisely the "most sensitive moment" for the U.S. economy to enter a recession.

In other words, the risk of recession is greater.

Is Wall Street's judgment correct?

This may need to be viewed from two aspects: on the one hand, this may be Wall Street's rhetoric to force the Federal Reserve to cut interest rates more significantly, after all, a larger reduction in interest rates by the Federal Reserve will bring more abundant liquidity to Wall Street, and Wall Street can use this to push up the stock market to profit; on the other hand, out of consideration for maintaining the status of the U.S. dollar, the timing of the interest rate cut is indeed a bit late, and high interest rates have indeed put great pressure on the U.S. domestic economy, leading to market concerns about a possible recession in the U.S. economy.

Therefore, in order to reverse market expectations, the Federal Reserve needs to increase the magnitude of the interest rate cut.

It seems that both situations may exist now, but the key is to see whether the yield inversion of Treasury bonds necessarily indicates an economic recession.

Perhaps it should not be judged mechanically and dogmatically, at least everyone needs to distinguish whether the long-end Treasury bond yield is lower than the short-end Treasury bond yield is "naturally induced" or "artificially caused".

After the 2008 financial crisis, the Federal Reserve invented the "Operation Twist" tool.

The so-called "Operation Twist" refers to: the Federal Reserve weakens the traditional interest rate control method of "short-end interest rates affecting long-end interest rates" - the transmission method, and instead directly purchases long-term Treasury bonds, releasing long-term funds while directly lowering the yield on long-term Treasury bonds.

In this process, the Federal Reserve must necessarily control the short, medium, and long-term interest rates systemically to ensure that the yields on Treasury bonds of various maturities do not invert, which also increases the operational difficulty of the Federal Reserve's monetary policy.

However, against the backdrop of the continuous decline in long-term Treasury bond yields, as long as the price of 2-year Treasury bonds falls slightly, the yield will rise accordingly, and it is very easy to cause the yield inversion of Treasury bonds.

Does this "artificially caused" yield inversion of Treasury bonds necessarily mean an economic recession?

The answer is not so simple.

Because lowering long-term interest rates is the result of the Federal Reserve's artificial intervention, it is the result of injecting a large amount of long-term liquidity into the market, and it is a means to reverse the market's negative expectations.

Under the background of the Federal Reserve's deliberate strengthening of the market's long-term liquidity, the capital market is active, and enterprises can easily obtain low-priced long-term capital, the economic expectations and activity will inevitably be greatly improved.

However, the "naturally induced" situation is different.

The aforementioned financial logic - because the U.S. economic situation is better in the short term than in the more distant future, the interest rates for the more distant future need to be lower than the short-term interest rate levels - is established.

If the yield inversion of Treasury bonds is the market's natural judgment, it may not be as simple as forcibly raising the yield on long-term Treasury bonds, but it may be necessary to start from preventing an economic recession and adopt more policy measures to vigorously reverse the market's negative expectations.

Is the current situation in the U.S. "artificially caused" or "naturally induced"?

The possibility of "artificially caused" is relatively large.

The reason is that the U.S. Treasury has recently issued a large number of short-term bonds and a small number of long-term bonds.

Based on the insufficient demand for long-term bonds, the price of long-term Treasury bonds has risen, and the yield has fallen.

Wall Street even believes that the U.S. Treasury is manipulating the Treasury bond market, which is a strategy to relax finance.

However, Yellen refuted, saying: "I can assure you, 100% there is no such strategy, we have never discussed anything like this."

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