Too often when it comes to economics and finance, previous trends—correlations, to be specific, like that between yield curve inversions and eventually recessions—come to be treated as inviolate natural law. That can lead to significant risk and strategic mistakes.

When there’s a yield curve inversion, with interest rates on shorter-term bonds being higher than on longer-term, frequently, although always, there’s eventually a recession within a year or so. The explanation is that collectively investors as the “market” perceive that the economy will slow over the longer run, with the Fed lowering short-term rates to prevent a recession. That means when bonds come to maturity, rates will be lower, meaning they won’t make as much by reinvesting, so they demand higher interest rates on short-term bonds to make up the difference.

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Erik Sherman



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