Inverted yield curves send shock waves through US and Australian Markets
The United States (US) Treasury yield curve inversion hit the lowest levels since early 2007.
On Monday (Early Tuesday AEST), the yield on 10-year Treasury bonds dropped to 1.75 per cent. In contrast, the yield on 3-month Treasury bonds is at 2.05 per cent, the yield 1-year Treasury bonds are at 1.78 per cent, and the yield on 3-year and 5-year Treasury bonds is at 1.55. The result of these yields is an inverted US Treasury yield curve as shown below.
The Australian yield curve is inverted, but not to the same extent as the US yield curve. Currently (Tuesday 6 August 2019), the yield on 10-year bonds is at 0.984 per cent. In contrast, the yield on 1-year bonds is at 0.926 per cent, the yield on 3-year bonds is at 0.662 per cent and the yield on 5-year bonds is at 0.682 per cent. The Australian yield curve is shown below.
How does a yield curve invert?
An inverted yield curve generally represents investor confidence in the future. The yield curve achieves this by showing that bonds with the longest maturity (30-years) have a higher yield than short-term bonds (3-months). When the yield curve begins to invert, it shows that short-term bonds generate a greater yield than medium to long-term bonds. The main reason for this occurring is that investors are buying medium to long-term bonds over short-term bonds. Overall, this increases the price of medium to long-term bonds while reducing the yield of these bonds, causing a flattening or inversion of the yield curve.
What does an inverted yield curve mean?
The inverted yield curve is a worrying sign for investors and the broader economy. The inverted yield curve represents a scenario where investors are concerned about the short-term state of the economy and financial markets. It points to the strong possibility of a recession over the next twelve months or so.
What caused further inversion of the yield curve?
The yield curve generally inverts when there are a number of domestic and global economic and political concerns. On Friday (2 August 2019), US President Donald Trump announced new tariffs on Chinese imports. In particular, President Trump tweeted “U.S. will start, on September 1st, putting a small additional Tariff of 10% on the remaining 300 Billion Dollars of goods and products coming from China into our Country. This does not include the 250 Billion Dollars already Tariffed at 25%”. In response, the Chinese Reserve Bank dropped the Chinese yuan below 7 against the US dollar, in order to combat the increase in US tariffs. The major catalyst for future global economic concerns is the continuation and possible further escalation of the US-China trade dispute.
What is the effect of an inverted yield curve on the Australian financial markets?
In reaction to concerns over the US/China trade ware, the ASX fell by around 2 per cent on Monday 6 August 2019, and a further a 2.9 per cent on the opening of trading on Tuesday 6 August 2019. The market has partially bounced back following this sharp drop. In addition, the yield on the 10-year has fallen below 1 per cent for the first time in Australian history.
If US-China trade tension escalates and global economic growth continues to slow, Australian investors could expect a slowing down in financial markets, and the Australian economy as a whole.
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