What Is an Inverted Yield Curve?
An inverted yield curve occurs when short-term bonds have higher interest rates than long-term bonds. It’s unusual and is seen by some as a recession warning.
May 4, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
The bond market is closely watched by investors, economic policymakers and politicians. To the trained eye, activity in the global bond market can explain a lot about what is going on in the economy — and more importantly, what big investors expect to happen soon.
One metric that is closely watched is the “yield curve.” The curve is usually positive but it can turn negative (or “inverted”) as well. What is an inverted yield curve — and why does it matter?
What is a yield curve?
A yield curve is a way to compare bonds of different maturity dates — for example, a 2-year treasury note vs. a 10-year treasury note.
This measurement compares bonds with the same credit rating but different maturity dates.
For example, a common yield curve might look at US Treasury notes with different maturity dates — but you wouldn’t use a yield curve to compare a US Treasury note to a corporate junk-bond.
A normal yield curve is positive, meaning that short-term bonds have lower interest rates than long-term bonds. This is because long-term bonds require investors to lock up money for longer periods of time, exposing them to interest rate risk (and forcing them to demand higher interest rates for that risk).
The slope of the yield curve can tell us about the market’s expectations for future interest rate changes.
The most commonly watched yield curve is the curve between the 10-year Treasury note and the 2-year Treasury note, but Wall Street analysts also look at other curves and yield spreads as a proxy for the yield curve.
The yield curve is calculated using data that is published daily by the Department of the Treasury. This data can be used to graph the yield curve.
Yield curve shapes
There are three “standard” shapes for a yield curve: normal (upward sloping), inverted (downward sloping) and flat.
A normal, upward-sloping yield curve means that long-term bonds have higher interest rates than short-term bonds. This is the case the vast majority of the time. This indicates a high likelihood of economic expansion and is often seen as a positive sign for the stock market and the economy as a whole.
But sometimes the yield curve can turn negative or “invert.”
What is an inverted yield curve?
An inverted yield curve occurs when the yield curve turns negative. This means that short-term bonds have higher yields than long-term bonds. As such, an inverted yield curve can also be referred to as a negative yield curve.
An inverted yield curve is highly unusual but it does happen at times — usually when the Federal Reserve is raising short-term interest rates in an attempt to tame inflation.
When there is an inverted yield curve, investors see a high likelihood of the economy slowing down. For this reason, an inverted yield curve is often thought of as a predictor of a coming recession.
What does an inverted yield curve mean, and why does it matter?
An inverted yield curve means that short-term interest rates are currently higher than long-term interest rates on bonds with different maturity dates but the same credit rating (2-year notes vs. 10-year notes, for instance).
Why does it matter? An inverted curve means that investors expect long-term interest rates to slump and the economy to slow down.
It’s used as a forward-looking predictor of economic growth or recession. And it’s been a fairly reliable predictor of recessions, in fact.
The yield curve inverted briefly in 1998, but the Fed quickly cut interest rates to avoid a looming recession
The yield curve inverted in 2006 and the Great Recession started in late 2007
The yield curve briefly inverted in 2019 and the US economy experienced a brief recession in early 2020 (although this was largely due to the Covid-19 pandemic)
An inverted yield curve signals to investors that the market is expecting a decrease in long-term interest rates and/or a slowdown of economic growth. For this reason, it’s closely watched by market participants, investors, hedge funds and policymakers.
Ultimately, an inverted yield curve is simply one indicator we can look at to gauge the market’s expectations. It is used by some as a recession indicator but officials at the Federal Reserve have repeatedly stated that there is no single “best” predictor of coming recessions.
For everyday investors, the yield curve should not be a major concern. It’s unlikely that a negative yield curve should impact your financial decisions or investment decisions. If you have questions, it’s wise to speak with a qualified fiduciary financial advisor.
Want to learn more about investing and the market? Here are some helpful resources:
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