2022-03-25

Could Yield Curve Inversion Be the New Normal?

Greece's yield curve inverted during their sovereign debt crisis because people holding 20-year and 30-year bonds figured the crisis will be over by the time those bonds mature. Yields on shorter-term bonds soared because if Greece is broke right now, they can't pay the bonds maturing now.

Let's say you (the market) wants a 2 percent real return. If inflation is 8 percent, but you don't think it lasts more than 2 years, you might demand 10 percent yield on 2-year paper and a 4 percent yield on 30-year paper if you assume 2 percent inflation will be the norm for most of that period.

The yield curve could become extremly inverted if inflation picks up and the bond market still doesn't panic. That will likely blow up some funds. If the whole yield curve steepens because inflation becomes endemic, then the economy and financial markets will be crushed. Or the bond market is right, all this inflation is pretty much over, and the Fed will successfully crush inflation by collapsing the commodity markets.

Yield curve inversion shouldn't last too long because something will break, but it is possible that inversion goes on far longer, and goes far deeper, than most market participants are expecting today.

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