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Below is the excerpt from the article Term Structure Of Interest Rates

Downward sloping — short-term yields are higher than long-term yields. Dubbed as an "inverted" yield curve and signifies that the economy is in, or about to enter, a recessive period.

If I understand that correctly, it means that investors begin to sell short-term bonds when they suppose the economy is approaching a recession? But the yield curve shows treasuries yields and treasuries are considerred to be risk-free, so why do investors begin to sell them?

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"Risk Free" only means that the risk of default is zero (the Fed will always pay off its bonds by borrowng or printing more money) and the return is guaranteed if they are held to maturity. But they can certainly go down in value if interest rates rise, since a bond that pays 3% is more valuable than one that pays 2% (all else being equal).

So if investors think that interest rates will rise (possibly due to recession, possibly for other reasons) then they will sell bonds now and buy them at higher interest rates later.

That is in incredibly simplified example, but your main question seems to be around the bonds being "risk free" when in fact there's no risk of default but certainly risk of losing value.

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It's more about investors buying long-term bonds than selling short-term ones. The shortest-term rates are controlled by government central banks, in an attempt to manage the economy. They typically reduce short-term rates in a recession.

But if a recession is forecast, long-term rates drop sooner, because investors expect short-term rates to drop. Another way to view it is that investors buy long-term bonds to "lock in" their yield, fearing that if they don't do so, the available rates (and thus returns) will be lower in the future.

Sometimes a recession is associated with increasing short-term rates, but that tends to be a matter of the central bank's hiking action causing a recession rather than responding to it. This can happen when the central bank is concerned about inflation, and is willing to risk a recession to get it under control.

The general cycle of events would be: long-term rates up (inflation expectations) -> short-term rates up (prevent overheating) -> long-term rates down (recession expectations; this is the point where the yield curve is inverted) -> short-term rates down (fight the recession) -> long-term rates up...

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  • Thank you. "But if a recession is forecast, long-term rates drop sooner, because investors expect short-term rates to drop" - did you mean fed rates or bond yields here?
    – Daniel
    Feb 3, 2022 at 21:06
  • @Daniel By "short-term rates" I mean both Fed rates and short-term bond yields. These are closely tied together. The Fed sets the "boundary condition" (the shortest end of the yield curve, overnight rates). Short-term bonds (up to 1-2 years, say) typically respond in a direct fashion because Fed policy is fairly predictable over that horizon. The further out the yield curve you go, the less the rates are driven by current Fed policy and the more by expectations of future conditions.
    – nanoman
    Feb 3, 2022 at 22:27

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