What Is an Inverted Yield Curve?
Long-term interest rates are lower than short-term interest rates, as shown by an inverted yield curve. The yield falls down sharply as the maturity date gets farther away under an inverted yield curve.
Inverted Yield Curve – Definition
Contents
The inverted yield curve, also known as a negative yield curve, has historically been an accurate predictor of economic downturns.
KEY TAKEAWAYS
- Yields on bonds with comparable maturities are graphically represented by the yield curve.
- When debt securities with shorter maturities have higher yields than longer-term assets with the same credit risk profile, the yield curve is said to be inverted.
- An inverted yield curve is unique because it shows bond investors’ expectations for a drop in longer-term interest rates, which is normally linked with recessions.
- Several yield spreads are used as a stand-in for the yield curve by traders and economists.
Understanding Inverted Yield Curves
Yields on bonds with comparable maturities are graphically represented by the yield curve. The term structure of interest rates is another name for it. For instance, the U.S. Treasury releases daily Treasury bill and bond rates that may be shown as a curve.
Analysts often reduce yield curve signals to a spread between two maturities. This makes it easier to decipher a yield curve with an inversion between certain maturities but not others. The drawback is that there isn’t universal agreement on which spread is the best early warning system for a recession.
The yield curve typically slopes higher, indicating that those who retain debt for extended periods of time have assumed more risk.
When long-term interest rates fall below short-term rates, this is known as an inverted yield curve and indicates that investors are shifting their money away from short-term bonds and toward long-term ones. This indicates that the market as a whole is becoming less optimistic about the economy’s future prospects.
In the contemporary age, such an inversion has been used as a pretty accurate recession predictor.
Financial market players usually pay close attention to yield curve inversions because of their rarity and the fact that they have historically preceded recessions.
Choose Your Spread
While market participants have more frequently focused on the yield spread between the 10-year and two-year bonds, academic studies of the relationship between an inverted yield curve and recessions have tended to look at the spread between the yields on the 10-year U.S. Treasury bond and the three-month Treasury bill.
In March of 2022, Federal Reserve Chair Jerome Powell said that the spread between the current interest rate on three-month Treasury bills and the market price of derivatives anticipating the same rate 18 months from now is his preferred metric for gauging recession risk.
Previous Instances of Yield Curve Inversion
Ever since it gave a false positive in the mid-1960s, when it failed to predict a recession, the 10-year to 2-year Treasury spread has been a dependable harbinger of economic downturn.
Its forecasting skills have been questioned by a lengthy number of high-ranking U.S. economic authorities, notwithstanding this.
After the Russian debt default of 1998, the 10-year/two-year spread momentarily reversed. The Federal Reserve’s swift action in reducing interest rates prevented a recession in the United States.
A yield curve inversion may have been a reliable predictor of economic downturns in prior decades, but it does not trigger recessions. Bond prices instead reflect investors’ anticipation of lower returns on longer-term investments, as is customary during economic downturns.
Over most of 2006, the spread was negative. In 2007, long-term Treasury bonds ended up outperforming equities. Towards the end of 2007, a period known as the Great Recession got underway.
At a short period on August 28, 2019, the gap between the 10-year and 2-year rates reached negative. In February and March of 2020, the U.S. economy contracted a recession due to the advent of the COVID-19 pandemic, a factor that could not have been included into bond prices in the preceding six months.
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Does the Present Inverted Yield Curve Indicate an Imminent Recession?
Finally, in late 2022, the yield curve inverted once again against the background of rising inflation.
The following are the yields on US Treasuries as of December 2, 2022:
- Yield on a three month Treasury bond is 4.22% at now.
- Yield on a two-year Treasury note: 4.28%
- The yield on the 10-year Treasury bond is now 3.51%.
- The current yield on 30-year Treasuries is 3.56 percent.
As can be seen above, the yield on the 10-year U.S. Treasury is 0.77 percentage points lower than the yield on the 2-year note. That’s a huge negative margin, the largest since the end of 1981, just before the start of the Great Recession.