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What an inverted yield curve says about Canada’s economy

The yield on the five-year Canadian government bond briefly slid below the level for shorter-term debt Tuesday – an inversion that signals deepening concerns about the economy and the likelihood of further rate cuts by the Bank of Canada.

What is an inverted yield curve?

Simply put, the yield curve shows the relationship between short-term interest rates and those for longer-term debt. Typically, investors demand higher rates for the increased risk of holding bonds or other debt instruments for longer periods, which means the yield curve slopes upward.

When the difference between short and long rates narrows, the curve starts flattening. And when short-term rates move higher than intermediate and longer rates, the normal pattern is reversed, or inverted.

What does it tell us?

The yield curve is an important gauge of economic and financial market health. When the slope of the curve steepens, it signals that investors – and businesses – are more confident about acquiring assets other than safe government bonds in an improving economy.

A flattening curve is a sign that investors are losing confidence in the growth story. And when it inverts, investors are battening down the hatches in expectation of future storms.

What does an inverted curve mean for the economy?

Nothing good. Inversions have preceded the past seven recessions, typically by about a year to 18 months. When the curve flattens or inverts, trouble is usually lurking in the neighbourhood in the form of more costly financing for banks and other companies that typically borrow their money at short-term rates. It also means lower returns for pension funds and other investors that need to hold longer-term bonds. And even if the economy manages to muddle through, slower growth will translate into reduced corporate profits and lower returns for equity investors.

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