Under normal circumstances longer term bond yields is higher than the shorter term bond yields as shown below.
When more and more investors are worried about an economy slowdown with expectation of lower interest rate, funds will be buying into longer term bond to locked-in a certain guaranteed return. Demand will drive the bond prices higher and that will lower the yields. At the same time when demand for the shorter-term bonds is lower that will push down the bond price and yield will go higher correspondingly. We will have a yield curve inversion.
Stocks began falling on Tuesday when Jeffrey Gundlach, CEO of Doubleline Capital, who oversees more than US$123 billion in assets told Reuters that this inversion signals a weakening economy. When the benchmark S&P 500 fell below its 200-day moving average, it triggered more selling activated by algorithmic trading (an automatic computer programed driven selling).
Last Monday was the first time in the last few years when 5-year bond yield dropped below the 3-year bond yield.
It may be good to look at impact of 'yield curve inversion' on the previous market's plunge, the 2007's 53% major correction where Dow dropped from 14,093 to 6,626 level.
But further checking revealed that this partial yield curve inversion was there in 2007 and was there for the whole of 2006. In fact the first time it appeared was on 28 November 2005 when Dow was at 10,877 level.
Dow was able to move from 10,877 on 28 November 2005 to 14,093 on 8 October 2007 (22 months period) gaining 3,216 points or 29.5% before Dow finally collapsed and plunged to 6,626.
My guess is within the next two years Dow will completed its major wave 8 and 9 before the final plunge.
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