What Is an Inverted Yield Curve?
An inverted yield curve represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality. The yield curve is a graphical representation of yields on similar bonds across a variety of maturities. A normal yield curve slopes upward, reflecting the fact that short-term interest rates are usually lower than long-term rates. That is a result of increased risk premiums for long-term investments.
When the yield curve inverts, short-term interest rates become higher than long-term rates. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession. Because of the rarity of yield curve inversions, they typically draw attention from all parts of the financial world.
Inverted Yield Curve
- An inverted yield curve reflects a scenario in which short-term debt instruments have higher yields than long-term instruments.
- Typically, long-term bonds have higher yields than short-term bonds.
- An inverted yield curve is often seen as an indicator of an impending recession.
- Because of the scarcity of yield curve inversions, they tend to receive significant attention in the financial press.
Understanding Inverted Yield Curves
Historically, inversions of the yield curve have preceded many recessions in the U.S. Due to this historical correlation, the yield curve is often seen as a way to predict the turning points of the business cycle. What an inverted yield curve really means is that most investors believe interest rates are going to fall. As a practical matter, recessions usually cause interest rates to fall. Inverted yield curves are often, but not always, followed by recessions.
Inverted yield curves are often, but not always, followed by recessions.
For simplicity, economists frequently use the spread between the yields of ten-year Treasuries and two-year Treasuries to determine if the yield curve is inverted. The Federal Reserve maintains a chart of this spread, and it is updated on most business days.
A partial inversion occurs when only some of the short-term Treasuries have higher yields than long-term Treasuries. An inverted yield curve is sometimes referred to as a negative yield curve.
Yields are typically higher on fixed-income securities with longer maturity dates. Higher yields on longer-term securities are a result of the maturity risk premium. All other things being equal, the prices of bonds with longer maturities change more for any given interest rate change. That makes long-term bonds riskier, so investors usually have to be compensated for that risk with higher yields.
If an investor thinks that yields are headed down, it is logical to buy bonds with longer maturities. That way, the investor gets to keep today's higher interest rates. The price goes up as more investors buy long-term bonds, which drives yields down. When the yields for long-term bonds fall far enough, it produces an inverted yield curve.
The shape of the yield curve changes with the state of the economy. The normal or upward sloping yield curve occurs when the economy is growing. When investors expect a recession, they also expect falling interest rates. As we know, the belief that interest rates are going to fall causes the yield curve to invert.
It is perfectly rational to expect interest rates to fall during recessions. If there is a recession, then stocks become less attractive and might enter a bear market. That increases the demand for bonds, which raises their prices and reduces yields. The Federal Reserve also generally lowers short-term interest rates to stimulate the economy during recessions. That makes bonds more appealing, which further increases their prices and decreases yields.
Historical Examples of Inverted Yield Curves
- In 2019, the yield curve briefly inverted. A series of interest rate hikes by the Federal Reserve in 2018 raised expectations of a recession. Those expectations eventually led the Fed to walk back the interest rate increases. The belief that interest rates would fall proved to be correct, and bond investors profited. As of November 2019, it was not clear if a recession would occur.
- In 2006, the yield curve was inverted during much of the year. Long-term Treasury bonds went on to outperform stocks during 2007. In 2008, long-term Treasuries soared as the stock market crashed. In this case, the Great Recession arrived and turned out to be worse than expected.
- In 1998, the yield curve briefly inverted. For a few weeks, Treasury bond prices surged after the Russian debt default. Quick interest rate cuts by the Federal Reserve helped to prevent a recession in the United States. However, the Fed's actions may have contributed to the dotcom bubble.