One of the most popular economic recession indicator which in many case investors and traders look at is yeild curve. Because if you look at the last 60 years historical data ,every major recession that took place in US since the 1960 including the 2008 financial crisis, one common pattern you would find is inverted yield curve . Still this concept is theotically accepted but many investors are still believing it, so it will be useful to know about what is yeild curve how does it inverted.
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| Yield Curve |
What is Yeild Curve ?
Yeild Curve refers to i.e if you draw the chart (graph) for different interest rates that were paid to people from different bond instruments is called yeild curve. The term recession indicator is coined by the Duke university professor campbell harvey in 1986. At that time many economist and investors study lot about the stock market and US economy to predict the market. As campbell harvey saw his colleuges were failing in that he chose the least volatile market that is bond market.
if explained in example it will be easiler to grasp. let's take Indian Sarkar as an example. let take the government wants to build a bridge in Tamil Nadu. let assume for that the governments needs 10,000 ruppees, to raise the fund what will the government do is government will issued a bond , the maturity period can be whatever it can be 1 year or 2 year or upto 10 years. Government will now issued ten 10,000 ruppee bond you and i as a investor can buy that bond and hold it as a asset as long as the maturity date ends. One question will raised in your mind. Why do i need to buy bond from government i can invest that in stock market but since stock market is volatile you can't put your emergency funds like education money for your kids or money that you will purchase home in the next 5 to 10 years. where do you put this amount, in FD no chance don't ever do that becasue the inflation will eat up your money. It will be safer to buy government bonds because the government can't be default ie bankrupt so the governemnt will return your money plus the interest rate in this case you will have 10,000 captial money and the interest rate for 10 years let assume the interest rate is 10% is 25,937 + your inital amount of 10,000 ruppees in total you will get 35937 at the end of the 10 years.
What is inverted yeild curve ?
Inverted yeild curve occurs when the long term interst rate is lower than the short term interest rate. Why doest the long term interest rate falls this happens when the demand for long term bond suddenly surge, as demand increases then the price of the long term bond also increases. Yeild curve and interest rate have a inverse relation. Hence the long term bond interest rate decreases. As the more investors shift their money to long term bonds, the interest rate of the short term bond increases and thus the yield curve is inverted.
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