The inversion of the yield curve has preceded most recessions. This is the reason trend forecasters use it as an indicator of the future when applied to business activity. It has a valid basis when one considers the underlying factors that are used to evaluate the price of bonds.
A yield curve is the relationship between the cost to purchase a bond to the amount an investor will receive over the term of the bond. A bond is a financial instrument a company, a business entity or a country floats to secure a source of funding to expand or maintain the company or the country. The investor having the desire to receive a profit for their investment will analyse the company’s financial statements to assess the odds of getting this profit. Note that this is a simple explanation as the prudent investor will also analyse other data such as the market to estimate the future demand for the company’s product as well as the company’s competitors. Assuming that all looks well financially, the investor will expect that the bond price will increase.
The price of the longer term bonds normally should be higher than the shorter term bonds. This is based on the idea of the time value of money. A dollar today theoretically should be more valuable than a dollar tomorrow because if one were to invest today’s dollar, tomorrow they should have more than a dollar (they will gain interest). Thus if one commits their (today) dollar for a longer term, they should expect to receive a higher yield.
When the yield curve inverts, this is saying that investors believe that loaning money to a company for a longer period will result in getting a smaller return. This portends that in the future, the company will be a riskier investment than it is currently. In other words, the trend for companies as well as the economy is downward, hence a recession.
When one takes into account the huge amount of debt worldwide, it makes the chance for a recession more probably. Debt acts as draw on net income or in a country’s case, GNP / GDP. The debt instrument requires that interest is paid on the principal, this interest has no economic gain associated with it to the borrowing entity, meaning it is a pure expense. The money (principal) borrowed will be used to say buy a new asset that will produce a product which will be sold and return a profit, this is not true of the interest due on the debt. As the debt increases, the debt service also increases resulting in an addition burden on the entity’s net income / profits. The entity has the option to increase their prices to the consumer or in the case of a country, increasing its citizen’s taxes. Doing this will likely reduce the demand for their product. This results in lowering the overall value of the entity and possibly leading to bankruptcy.