What The Heck Is An Inverted Yield Curve? And Why Does It Predict A Recession?

Key Takeaways

• A yield curve sheds light on what many people view as the economy’s current state and may be used to forecast changing business dynamics, particularly a downturn.
• Always be aware that the yield curve is an indicator, not a forecast. Using the yield curve as the only point of data will not paint a complete picture.
• That said, an inverted yield curve has accurately predicted the ten most recent recessions.

There has been so much emphasis on interest rates lately. The truth, however, is far more complicated, with rates on individual bonds frequently behaving very differently based on their maturity dates. This article will explain a yield curve’s importance and whether an inverted yield curve means a recession is coming.

What is a yield curve?

A yield curve can be drawn for any type of bond, from corporate bonds to municipal bonds. Let’s go over the fundamentals of yield curves, using the U.S. Treasury yield curve as an example.

Whenever people buy Treasury securities, they effectively provide the government with funds. Simply stated, this is a loan. In return, the Treasury pledges to repay its investors after a certain amount of time (known as maturity) and offers investors a predetermined rate of loan interest, known as the coupon.

While the coupon on a U.S. Treasury bond doesn’t fluctuate with time, the yield on the bond will. This is because yield accounts for the continually fluctuating values of Treasurys in the secondary market.

The yield to maturity is the rate of return of all the cashflow earned from a bond, including coupon and principal repayment. The yield to maturity is inversely proportional to the bond price. If the bond price decreases, its yield to maturity increases.

On an X/Y graph, the horizontal X axis measures maturity. In the particular instance of the U.S. Treasury yield curve, the X axis begins on the left with short-term Treasury notes of maturities ranging from a few days up to a year, then moves to Treasury notes with maturities ranging from 1 to 10 years, and settles down on the right with bond maturities ranging from 20 to 30 years.

The current yield for every maturity is on the vertical Y axis, with the lowest yield at the bottom and higher yields at the top. A normal yield curve is upwards sloping. This is because investors need to be paid more for investing their money over a longer term. There is more risk in these investments, so the yield has to be higher.

What does a yield curve tell investors?

A yield curve sheds light on what many people view as the economy’s current state and may be used to forecast changing business dynamics. The yield curve effectively represents the view of most market players, so it provides a reasonably accurate picture of what is happening within the economy.

If the market players are worried about potential economic growth, short-term yields will rise as investors look to invest in longer-term bonds. Additionally, short-term yields will rise if the Federal Reserve increases interest rates, as the federal funds rate highly impacts shorter maturity bonds.

During normal economic expansion, short-term yields will be lower, and long-term yields will head higher. Seems simple enough?

What happens when the yield curve inverts?

An inverted yield graph illustrates that long-term interest rates are less than short-term lending rates. Instead of the rate increasing as you move the maturity date further out, the yield actually decreases. Economists interpret this as a warning sign for a recession in the economy.

We are currently observing a major inversion of the yield curve with the 1-year treasury now 50 bps above the 10-year treasury yield.

A true inverted yield curve is not common. More common is a flattening of the yield curve. This means there is uncertainty as to which way the economy is headed, towards expansion or recession.

Does an inverted yield curve mean there is a recession?

Does an inverted yield curve indicate that a stock market drop and economic strife is coming? Very honestly, there is merit to this idea. In fact, an inverted yield curve has accurately predicted the ten most recent recessions.

With that said, the yield curve doesn’t cause downturns. Instead, it represents how investors see the trajectory of the U.S. economy. If people believe a slump is imminent, they will rush to buy long-term U.S. bonds.

When there are many buyers of long-term treasuries in a short time, the yield drops. Since there is less demand for shorter-term treasuries, the yield increases. The Federal Reserve also plays a part here. Short-term bonds will increase their yields if they begin to raise interest rates. This will naturally flatten the yield curve as the yield on longer-term bonds stays the same.

Rising interest rates and the yield curve

If long-term interest rates drop past short-term interest rates, the yield curve inverts and slides downwards. Long-term investors invest in longer-term bonds because of the uncertainty and risk surrounding the stock market in the near term. They would rather invest in a long-term bond and lock in a yield than risk losing money investing in more volatile stocks.

The shrinking yield spread between short- and long-term lending rates is a flattened yield curve. Whenever this occurs, the price of the bonds fluctuates accordingly. If the bond has a three-year maturity, and the three-year yield falls, the bond’s price will rise. The bonds price changes to keep parity with changing rates and existing bonds in the secondary market.

A flattened yield curve might indicate economic weakening because interest rates and inflation will remain low for some time. Investors anticipate modest growth in the economy, and bank lending slows.

When the yield curve steepens, the difference between short-term and long-term bond interest rates increases. This means that long-term bond yields are going up faster than short-term bond rates, or short-term bond yields are declining while long-term bond yields increase. As a result, long-term bond prices will fall compared to short-term bond prices.

A steepening graph upward usually signals more economic growth and inflationary expectations, which results in increased lending rates. A 2-year note with a 1.5% yield and a 20-year note with a 3.5% yield is one example of a steepening yield curve.

Bottom Line

The yield curve is an indicator, not a forecast. Using the yield curve as the only point of data will not paint a complete picture. You need to look at the economy as a whole, along with the trend of inflation, the creation of new jobs, wage growth, and what the Federal Reserve says. Only then can you make educated guesses about the economy’s future direction.

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