What is the Inverted Yield Curve?

What is a Yield Curve?

A yield curve is a graphical representation of interest rates on bonds of increasing maturities. The relationship between interest rates and the maturities of bonds that it represents is known as the term structure of the interest rates of the bonds. The graph has interest rates on the vertical y-axis and times to maturity, such as 1 year or 5 years, on the horizontal x-axis. 

You can usually see that the yield curves are upward-sloping, meaning that short-term bonds have lower yields than long-term bonds. You see this because investors demand a higher yield to compensate for the increased risk of holding a bond for a longer period of time. 

It is important that while comparing interest rates and maturities, all other factors of the bonds being considered be the same, e.g. similar credit quality. Otherwise, the comparison will be faulty.

What is an Inverted Yield Curve?

An inverted yield curve occurs when short-term bonds have higher yields than long-term bonds. On the graph with the yield on the vertical y-axis and time to maturity on the horizontal x-axis, an inverted yield curve has a negative slope. In other words, as the time to maturity increases, the yield decreases. This is an unusual event, and it is often seen as a sign of a recession.

Figure: These are the yield curves for US treasuries in January 2007, January 2008 and January 2009. Notice how the curves were inverted in 2007 and 2008 because of the anticipation of recession, while the 2009 one has a sharp positive slope because the recession was nearly over by then. The chart has been taken from Financial Times which in turn took it from the US Treasury.

We can now explore the inverted yield curve meaning in detail in the coming sections.

When Does the Yield Curve Get Inverted?

You could see an inverted yield curve in the bond market if the investors feel that there is a higher risk in investing in the bond in the short run than in the long run, despite the long run having the risk related to a longer time period. The meaning of this could be that the investors’ view regarding the performance of the economy or the issuing entity is rather negative or bearish in the short run. As a result, they are willing to accept lower yields in long-term bonds and are demanding higher rates for short-term bonds. 

Investors may also accept lower rates of interest for long-term bonds if they believe that the rate of growth of the issuing entity will not be too high in the long run.

What Are the Implications of The Inverted Yield Curve?

You may often see an inverted yield curve as a sign or a precursor of a recession. This is because it suggests that investors are more pessimistic about the near future of the economy. When investors are pessimistic, they are less likely to invest in businesses, and this can lead to a slowdown in economic growth. You may see investors moving away from stocks and increasingly investing in long-term bonds, which they consider safe-havens. There may be a sense of fear among the investors at large. As a result, a yield inversion may often directly precede a recession.

Should Investors be Worried?

You may see an inverted yield curve as a sign of a recession, but it is important to note that it is not a perfect predictor. There have been times when the yield curve has inverted without a recession following. You should, however, definitely see it as a warning sign.

You must also look at the inverted yield curve in multiple contexts. For example, if the yield curves of bonds are sometimes positive for different entities or credit qualities, then the signs of recession may not be as clear. There may also be a time lag between an inverted yield curve and the actual recession. You may need to consider this when switching to a different strategy based on the inverted yield curve early on.

You should take an inverted yield curve as an opportunity to review your portfolios and make sure that you are prepared for a potential recession. To do so, you may consider diversifying your portfolios and reducing your exposure to risky assets.

What Can an Inverted Yield Curve Tell an Investor?

An inverted yield curve can tell you a few things. First, it can tell you that other investors are sensing more risk in the current economy. This can be helpful information for you if you are making decisions about where to put your money. 

Second, an inverted yield curve can tell you that interest rates are likely to fall in the future. This information can be used by you to make decisions about whether to lock in your money at current interest rates or to wait until interest rates are lower. This includes the consideration that the short-term interest rates have gone too high and may fall in the near future, leading to an increase in the prices of short-term bonds soon.

The Relationship Between Instrument Price and Their Yield

You may find an inverse relationship between the price of a bond and its yield. When the yield of bonds offered in the market goes up, the price of your bond goes down. This is because investors are less willing to accept a lower yield on a bond if they can buy bonds with a higher yield in the market.

Historical Examples of Inverted Yield Curves

There have been several occasions in the past when the yield inversion has taken place, and a recession has followed. For example, the yield curve inverted in August 2006 as the Fed raised short-term interest rates. This was followed by the recession in December 2007. The yield curve also inverted in August 2019, and the COVID-19 pandemic caused a recession in 2020. However, it is hard to understand how the bond market could have predicted the recession so early on.

Why Is the 10-year to 2-year Spread Important?

The 10-year to 2-year spread refers to the difference between the yields of 10-year and 2-year bonds of the US Treasury. If the 10-year yield is lower than the 2-year yield, then the spread is negative. The 10-year to 2-year spread is one of the most closely watched yield curve spreads. This is because it has a long track record of predicting recessions. Therefore, it is used as a proxy or a leading indicator of recessions in the USA.

Conclusion

An inverted yield curve is an unusual event, and it is often seen as a sign of a recession. While it is not a perfect predictor, it is definitely a warning sign. Investors should take an inverted yield curve as an opportunity to review their portfolios and make sure that they are prepared for a potential recession. This may involve diversifying their portfolios and reducing their exposure to risky assets.

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