The yield curve, read properly: what inversion does and does not predict
Inversion is the most over-quoted signal in macro. What it actually encodes is an expectation of future easing - and the lag between signal and event is long enough to ruin a position.
Key takeaways
- – An inverted curve encodes an expectation that policy will be eased, usually because growth is expected to weaken
- – The lag between inversion and any real-economy consequence has historically been long and variable
- – How the curve re-steepens carries more information than the inversion itself
The yield curve plots the return on government debt across maturities. Normally longer borrowing pays more, compensating for time and uncertainty. When short yields exceed long ones the curve is inverted, and that configuration draws more commentary than almost anything else in macro.
What inversion actually says
An inverted curve is not a prophecy. It is an arithmetic consequence of what the market expects the central bank to do. Long yields approximate the average of expected future short rates plus a premium. When investors expect policy to be eased over the coming years, the average of those expected future rates falls below today’s rate, and the curve inverts.
So inversion says: the market expects rates to be lower later. The usual reason for expecting that is an expectation of weaker growth or lower inflation. That is a meaningful signal – but it is a signal about expectations, not a mechanism that causes anything.
The lag problem
The gap between an inversion appearing and any measurable economic consequence has historically been long, and it has varied enough between episodes that it is close to useless for timing a trade. A position taken on inversion alone can be wrong for a very long time before it is right, which for a leveraged trader is indistinguishable from being wrong.
Re-steepening is the more useful signal
What happens after inversion carries more information. A curve can re-steepen in two very different ways, and they imply opposite things.
- Bull steepening – short yields fall faster than long ones. The market is pricing imminent easing. Historically this has tended to coincide with the deterioration actually arriving.
- Bear steepening – long yields rise faster than short ones. The market is pricing more inflation, more issuance or more term premium. This is a different world, and it is usually better for the currency than the first.
Which spread to watch
Different practitioners use different pairs of maturities, and they invert at different times, which is one reason the debate never settles. Rather than arguing about which is correct, watch the direction of several and treat agreement across them as the meaningful state.
For currency traders
Curve shape is a second-order input. The first-order input is the spread between two countries at the front end. Curve shape tells you what kind of regime you are in and therefore how a currency is likely to respond to news – not which way it goes tomorrow.
