George Gammon: Why the Yield Curve Inverts Before a Recession (The Real Reason)

In the post-World War II era, inverted Treasury yield curves have always accurately predicted a recession within 12-18 months. Currently, short-term Treasuries have higher yields than longer-dated ones. That’s an inversion.

That indicates there could be trouble ahead for the economy. Typically, investors will see an inverted yield curve, see assets continue to rise, and shrug it off. That could lead to a disastrous outcome.

When the yield curve inverts, it’s ultimately a sign that investors are heavily buying long-dated Treasuries.

That locks in higher interest rates before yields drop. And it also allows for investors to benefit from price appreciation. That’s because bond prices rise when yields fall.

The more long-term Treasuries are bought, the more the price rises and the more yields fall. Since there’s less demand for short-term Treasuries, those don’t move as much.

With yields falling at the long end of the curve, but little movement for short-dated Treasuries, an inversion becomes possible.

To some extent, the move can also become a self-fulfilling prophecy. Treasury yields are now at their highest levels since 2007, with the 10-year now closing in on 4.4 percent. But inflation has dropped to the 3 percent range.

That’s the first time in over a decade that bond yields have offered an inflation-adjusted real return. And it may entice more investors into bonds, taking money out of the stock market. If that happens, the prophecy would be fulfilled as stock prices decline.

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