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Inverted Yield Curve

What is an Inverted Yield Curve?

An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. The yield curve is a graphic representation of yields on U.S. Treasury bonds across a variety of maturities. In a typical environment, the curve slopes upward, reflecting the fact that short-term rates are often lower than long-term rates as a result of increased risk premiums for long-term investments. In an inverted yield curve, short-term 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 a yield curve inversion, it is a phenomenon which typically draws attention from all parts of the financial world.

A partial inversion occurs when only some of the short-term Treasuries (five or 10 years) have higher yields than 30-year Treasuries. An inverted yield curve is sometimes referred to as a negative yield curve.

Key Takeaways

  • An inverted yield curve reflects a scenario in which short-term debt instruments like U.S. Treasury bonds have a higher yield than long-term instruments.
  • Typically, long-term instruments have a higher yield than short-term instruments.
  • A yield curve is often seen as an indicator of an impending recession.
  • Because of the scarcity of yield curve inversions, this phenomenon tends to draw attention from many in the financial sphere.

Understanding an Inverted Yield Curve

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 an accurate forecast of the turning points of the business cycle. A recent example is when the U.S. Treasury yield curve inverted in late 2005, 2006, and again in 2007 before U.S. equity markets collapsed. The curve also inverted in late 2018. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are demanded, sending the yields down.

Inverted Yield Curve
Image by Julie Bang © Investopedia 2019

Yield and Maturity

Yields are normally higher on fixed-income securities with longer maturity dates. Higher yields on longer-term securities are a result of maturity risk premium because changes in the value of longer-term securities are more unpredictable with market interest rates potentially more unsettled over a longer time horizon.

However, yields on longer-term securities could be trending down when market interest rates are set to get lower for a foreseeable future to accommodate ongoing weak economic activities. Irrespective of their reinvestment rate risk, shorter-term securities appear to offer higher returns than longer-term securities during such times.

Yield and the Economy

The shape of the yield curve changes in accordance with the state of the economy. The normal or up-sloped yield curve may persist when the economy is growing and conversely, the inverted or down-sloped yield curve is likely to press on when the economy is in a recession. One underlying reason such a relationship exists between the yield curve and economic performance relates to how a higher or lower level of long-term capital investments may help stimulate or rein in the economy. By issuing longer-term securities with lower-yield offerings, businesses and governments alike can acquire needed investment capital at affordable costs to jump start a weak economy.

Yield and Bond Demand

What moves yields in the market is the varying demands for securities of different maturities at a particular time and under given economic conditions. When the economy is heading to a recession, knowing interest rates are to trend lower, investors are more willing to invest in longer-term securities immediately to lock in current higher yields. This, in turn, increases the demand for longer-term securities, boosting their prices and further lowering their yields.

Meanwhile, few investors want to invest in shorter-term securities when presented with lower reinvestment rates. With lower demand for shorter-term securities, their yields actually go up, giving rise to an inverted yield curve when yields on longer-term securities have come down at the same time.