Connection between negative interest rates and negative bond yields In an answer to one of my other questions: Why does falling global bond yields signal coming deflation, the answerer states:


  Whereas central banks set rates by policy, long term bond yields are determined by the market (i.e., supply-demand equilibrium). An inverted yield curve signals recession and implies rates are set too high relative to market expectations. If central banks set rates in positive territory when long term bond yields are negative, they will de facto force the yield curve to invert.


I cannot see the mechanism as to why if central banks set rates in positive territory when long term bonds yields are negative how this will cause the yield curve to invert.
I cannot see the mechanism as to why if central banks set rates in positive territory when long term bonds yields are negative how this will cause the yield curve to invert.


No need to seek a mechanism because the inverted yield curve occurs by definition in the scenario you describe. This Investopedia video defines inverted yield curve as follows:


  An inverted yield curve occurs when short term interest rates are higher than long term interest rates.


If short term rates are positive and long term rates are negative then short term rates must be higher than long term rates. Therefore, the yield curve will be considered inverted by definition.

Remember, central banks set the interbank overnight lending rate as a matter of policy. In the U.S., this is called the Federal Reserve Funds Rate. This is the shortest possible maturity. So this is the leftmost point on the yield curve.

By contrast, supply-demand equilibrium (i.e., the market) sets long-term bond prices. And, as we know, bond prices are inversely correlated to their yields. So when the market demand increases for long term bonds, their prices rise and their yields fall.