The yield curve has been in the news a lot lately in regards to a potential recession. For newer investors, here is a simple look at the mechanics of what this means.
Banks borrow money from the Fed, central banks around the world and other entities in the short term market and lend it to people in the long-term market. Also, the interest rates of depositors is determined by short term bond yields while interest rates of borrowers is determined by long term yields.
Basically, the bank borrows money for 1% and lends it to you for 4% and makes money on the 3 percent difference. When the yield curve is zero or negative, banks can’t make money by lending money, so they stop lending money. This means less money in the system and credit crunch. If people and businesses can’t borrow, the economy can’t grow.
That’s when there’s panic in the streets.
This also depends on how long the curve remains negative. If it dips for one day and reverses the next day it might be ok but if it is persistently negative, time to start getting worried.
If you can’t get loans you can’t buy cars, houses, mail order brides, roll your debt over. That’s how it causes recession. Fed can sometimes help by lowering short term rates if they are too high but it has little room to help if short term rates are already at low levels.
However, despite the above explanation, this doesn’t mean that a recession is imminent. There could be other factors at play here, but this isn’t a popular opinion in mainstream financial news cycles.
Banks put spreads on borrowed funds and the haircuts they take on deposits. Most banks are mostly relying on deposits for funding, not short term borrowed funding. Banks are not beholden to offer exactly the 10 year rate on a 10 year loan, they’ll add spread on new loans as the 10 year drops to protect their margin.
They will also cut deposit rates, and banks spend a lot of time and money heading against this risk.
The inverted yield curve is not an economy killer. It’s a signal that investors are fleeing riskier assets which could be a precursor to slowing economic growth due to many factors like the current trade war.