Purchasers of government debt [bonds] usually expect to receive a higher interest rate [bond yield] on longer term borrowings.
This is to compensate them for the effects of inflation and for the admittedly small chance of a default by the government.
Plotted on a graph, the bond yields on various maturities form a ‘yield curve’ that traditionally curves upwards.
Sometimes, short-term yields rise above longer longer-term ones, called an ‘inversion’.
The inversion in the yield curve has been a surprisingly accurate method of predicting future recessions.
In more recent years, analysts have used the Chicago Board Options Exchange (CBOE) Volatility Index [VIX] to measure expected price fluctuations in the S& P 500 Index. The VIX has earned the nickname ‘Wall Street Fear Gauge’.
The predictive nature of the VIX makes it a measure of implied volatility, not one that is based off historical data or statistical analysis.
The VIX is considered a reflection of investor sentiment, but should not be construed as a sign of an immediate market movement.
A high VIX reading should mean a fall in stock values, however, that relationship seems to be broken more recently where rises in the VIX level have also been accompanied by a continuing rise in the Stock Market.
That, plus the fear that some market participants might be able to manipulate the VIX for their own gain has caused analysts to look again at the Yield Curve to see what the future might hold for stock markets.
Analysts are now worried that because the US yield curve has been inverted for a full month this predicts a very difficult time ahead for the US economy.
Long-term interest rates are falling and the yield on 10-years Treasury Bonds has fallen sharply below the 3-month yield on US Government debt.
The gap between three-month and 10-year yields has been negative before every US recession of the last 50 years.
Meanwhile, Equity markets continue to reach new highs and are typically much slower to react to the potential for an economic slowdown.