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What is an inverted yield curve?

Posted on Friday, August 16th, 2019 by Chris Markoch

Summary - An inverted yield curve is one of the most accurate economic indicators that economists and market watchers use to predict that our economy is headed towards a recession. A yield curve illustrates the relationship between a bond’s price and its yield. In a normal yield curve, the yield on short-term debt instruments is lower than that of long-term debt instruments. So a 2-year Treasury bond pays a lower yield than a 5-year bond, which pays a lower yield than a 10-year bond, and so on.

The long-term end of the yield curve is influenced by investor sentiment which can dictate supply and demand. As the demand for long-term bonds increases (which is typically the case when investors are concerned about an economic slowdown) their yield goes down. Subsequently, the cost of short-term debt increases which means the yields on those instruments rise. If rising short-term yields become higher than falling long-term yields, the yield curve will flip, or invert.

While long-term interest rates are dictated by a number of factors such as inflation expectations, short-term interest rates are primarily influenced by the Federal Reserve’s interest rate policy. When the Fed raises rates, short-term rates tend to rise as investors move away from debt instruments and towards riskier assets. Conversely, when the Fed lowers rates, short-term rates tend to fall.

The presence of an inverted yield curve does not mean a recession is imminent. Prior to the financial crisis in late 2007, the yield curve inverted three times: once in 2005, once in 2006, and again in 2007. This is a reminder that the economy is a complex entity. In many cases, interest rate and monetary policy can be manipulated to sustain economic growth. 

Introduction

Buying bonds is similar to parking money into a certificate of deposit. An investor who agrees to lock up their principal for 10 years, 20 years, or even 30 years should expect a larger return (in the form of a higher yield) than the investor who chooses to put their principal in short-term investments (2-year, 5-year, etc.).

In a healthy, growing economy this model operates like clockwork. However, during times of volatility short-term investors may start to command a higher interest rate for tying up their principal. When this happens, the yield curve flips or inverts. In this article, we’ll take a look at the inverted yield curve and why investors regard it with such significance. We’ll also take a look at the three kinds of yield curves and the conditions that cause a yield curve to invert.

What is an inverted yield curve?

An inverted yield curve is an indicator of a market condition in which long-term debt instruments (such as 10-year U.S. Treasury Bonds) have a lower yield than short-term debt instruments of the same credit quality (such as 2-year U.S. Treasury Bonds). An inverted yield curve is also known as a negative yield curve.

The most recent example of an inverted yield curve occurred on March 20, 2019. At first, the inversion between 3-month and 10-year Treasury bonds was hardly noticeable. However, as this chart shows, on August 12, 2019, the gap had become more pronounced, triggering a large sell-off in the stock market.

Date

3-month

2-year

3-year

5-year

10-year

10-year to 3-month spread

March 20, 2019

2.46%

2.31%

2.24%

2.24%

2.44%

-0.02%

August 12, 2019

2.00%

1.58%

1.51%

1.49%

1.56%

-0.44%

 

What does an inverted yield curve signify?

An inverted yield curve has been a historically accurate predictor of an economic recession. For example, the U.S. Treasury yield curve inverted in 2005, 2006 and then again in 2007, not long after this inversion, U.S. equity markets collapsed in the ensuing financial crisis. However, what this shows is that, while the inverted curve may provide clues that there is a change in the business cycle, it does not say that an inversion is imminent.

Yield curves, in general, provide analysts and investors with insights into the future expectations for interest rates including possible increases or decreases in macroeconomic activity. When the inverted curve inverts, it suggests that investors are concerned about economic growth and actively seek to buy long-term instruments such as 10-year Treasury Bonds. However since a bond price and its yield have an inverse correlation, the more investors flock to 10-year Treasury bonds, the lower their yield becomes. Conversely, as short-term instruments become less expensive their yields rise. As a result, the yield curve flips or inverts.  

What are the three types of yield curves?

An inverted yield curve is one of three kinds of yield curves. In a normal yield curve, short-term interest rates are lower than long-term interest rates. This is called a normal curve because it stands to reason that investors who are keeping their money tied up for 10 years should be entitled to a higher interest rate than investors who are keeping their money locked up for a shorter amount of time. Even in times of market volatility, the normal yield curve still holds up, although it may flatten.

A humped yield curve looks like a bell curve. It marks a temporary condition where mid-term interest rates rise above both short-term and long-term debt instruments. This is also known as a partial inversion.

What causes a yield curve to invert?

To answer this question, you have to understand what factors affect different interest rates. Short-term interest rates are influenced by the market’s expectations for the direction of the Fed Funds rate. When the Fed raises rates (i.e. they become less accommodative), short-term rates will rise. When the Fed cuts rates (becomes more accommodative) short-term rates fall. Long-term rates are dictated by a variety of factors including the outlook on inflation, demand, and supply for a particular instrument, anticipated economic growth and the volume of trading activity.

The irony of this is that the Federal Reserve tends to cut rates to stimulate economic growth. But in cutting rates, many investors see it as a sign of a weakening economy and will flock towards the relative security that long-term debt provides. However, as buying activity increases on long-term instruments, the price of those instruments increases. Since the price of a bond and its yield have an opposite correlation when prices rise yields fall.

On the other hand, with fewer investors looking to buy short-term instruments their prices will go down, which means their yield will increase. As a result, the curve instead of looking like an upward sloping hill will now look to be on a downward slope.

How quickly does the yield curve invert?

A yield curve takes a while to invert, and it’s not uncommon for the yield curve to have several partial inversions (small humps) as 3-month yields may rise above 2-year yields, but perhaps not as high as 5-year yields. In this case, the yield curve rather than being a smooth, upward curve will look more like a stock chart with some peaks and valleys although the overall trend will be upward.

What is more common is a flat yield curve. This happens as the yields on short, medium and long-term instruments move towards each other. For example, in a normal curve, you might have 2-year Treasury instruments with a 2.5% yield, 10-year Treasuries at a 3.25% yield and 30-year offering a 3.75% yield. If the rates come towards each other let’s say 2.6%, 3%, and 3.25%, you can visualize how the slope of the curve would flatten. Typically, the yield curve will flatten for quite a while before completely inverting.  In some cases, the yield curve may go through a period of flattening and expansion before finally inverting.

Why does an inverted yield curve trigger investor emotions?

Although recessions are a normal part of a business cycle, many investors view them as something to be avoided at all costs. The average recession tends to not last very long. Historically, periods of economic expansion have outweighed periods of economic contraction. In fact, excluding the Great Depression, most recessions are measured in months, not years. Still, since recessions make equities less attractive, the “wealth effect” kicks in. During a recession, investors may feel like their personal net worth is declining, even though recessions can be a good time for investors to position their portfolio for long-term gains.

The final word on an inverted yield curve

An inverted yield curve occurs when the yields on short-term bonds are higher than long-term bond yields. An inverted yield curve is considered to be an abnormal situation and has been known to be a historical indicator of a recession at some point in the future. However, a yield curve can, and frequently does invert multiple times before the recession finally arrives.

A yield curve inverts because investors lose confidence in short-term economic growth. As investors buy long-term bonds, their price rises and their yield goes down. Subsequently, short-term bond prices fall but investors will demand a higher yield for taking on this debt particularly if they perceive the economy may be in a recession when the bond expires.

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