The Current Yield Curve Inversion, Explained

The yield on the 10-year bond recently fell below the rate paid by the Fed on bank reserves. That is, a bank gets paid more to lend to the Fed for a day than to lend to the Treasury for ten years. There is not merely an inversion between the 2-year and the 10-year bonds. Nor even the 3-month and 10-year. Now the overnight and 10-year bond are inverted.


Where the Mainstream Goes Awry

The mainstream view is that the yield of the 10-year bond predicts that the Federal Reserve will pivot, and reverse their course of rate hikes. This view is based on the assumption that the interest rate could be any level that free actors may set in a free market. That traders have a choice to hold bonds, or not.

Most people picture themselves, deciding whether to buy a bond vs, other things into which they could put their capital. They may even choose to hold cash, if they think rates are headed higher (rate is the inverse of bond price, if rates are rising then bond prices are falling and traders would want to sell before then). So logically, everyone should want to hold cash rather than bonds.

This would make sense in a gold standard (assuming interest rates were unstable in a gold standard, which they are not). Anyone would prefer the gold coin to a bond paying too little return. In the gold standard, one does not buy gold. One redeems a bond or a bank deposit. Redemption is a contractual right of the holder, and obligation of the issuer. The saver gave the issuer a gold coin in the first place, and redemption is simply the right to get back the gold. Redemption reduces funding to the issuer. The saver has the power to force credit to contract, if he does not like the terms or the risk.

But in irredeemable paper currency, there is no redemption. The idea that everyone could sell bonds is meaningless. To hold a money balance—dollars—is to be a creditor. Your choice is to lend to the Treasury directly via buying a bond, or to lend to the Treasury indirectly. You can lend indirectly by either holding paper dollar bills (aka Federal Reserve Notes), or by depositing the cash in a bank. The Fed and the banks use money to buy Treasury bonds. That is, you give them credit, and they extend this credit on to the Treasury.