Table of Сontents
- What Is an Inverted Yield Curve?
- What Does It Mean When A Yield Curve Inverts?
- Inverted Yield Curves as Recession Indicator
- Inverted Yield Curves from Recent History
- 2022 Inverted Yield Curve
- Bottom Line
- FAQs
An important economic indicator and a potential sign of a recession is an inverted yield curve. Find out what an inverted yield curve entails.
What Is an Inverted Yield Curve?
Longer-duration fixed-income assets often have greater interest rates than shorter-term securities. The additional danger of time is explained by this. The yield curve slopes downward and is referred to as being “inverted” on the rare instances when the yields on longer-duration instruments are lower than those of short durations.
As duration lengthens, the yield curve—a depiction of the yields for various durations of the same instrument—typically slopes higher. It’s not because the issuers of recently issued longer-dated bonds abruptly reduce the coupons that the curve inverts. It’s because supply and demand forces lead bonds’ prices to grow or fall, which in turn causes their effective yields to do the same. The yield curve demonstrates these practical
Yield Curve Movement
Long-term interest rates and yields are set by the markets, whereas short-term interest rates are often guided by the Fed’s monetary policy. In order to reward investors for taking on bigger risks with longer-term bonds, the market will often price longer-term bonds to yield more than shorter-term bonds.
Even though US Treasury bonds offer low yields, many investors will seek them out as a safe haven when they are concerned about the likelihood of economic instability and a stock market fall. It is believed that a low yield on a Treasury bond is preferable to a loss in the stock market.
Long bonds’ prices increase due to this unusual demand, which lowers their yields. It is because of this that the yield curve inverts.
Downward Sloping Yield Curve Chart
Both a positive (or normal) yield curve and a negative (or inverted) yield curve are depicted in the graph below.
Yield arcs (Seeking Alpha)
Recall that a negative yield curve indicates a negatively sloping curve, as seen above. It just means that the difference between short and long yields is negative; it has nothing to do with the real yield on longer-term bonds.
What Does It Mean When A Yield Curve Inverts?
A 10-year bond, for example, will have a lower annual yield than a 3-month bond when the yield curve inverts. This indicates that longer-dated bonds’ values have been driven up by investors to the point that they now yield less than short-term bonds.
Inverted Yield Curves as Recession Indicator
Investor worries about the economy and the stock market lead to an inverted yield curve. History demonstrates that when the yield curve is inverted, investors frequently predict impending economic deterioration correctly. Since World War II, a yield curve inversion has come before every recession.
However, recessions don’t begin right away once the yield curve inverts. The inversion often occurs six to eighteen months before the recession.
Inverted Yield Curves from Recent History
Yield Curve Shows Fair Valuation of the Stock Market
This graph shows that yield curve inversions preceded all recessions going back to 1960, including the ones that occurred in 2020, 2009, and 2001.
2022 Inverted Yield Curve
The 2-year Treasury yield and the 10-year Treasury yield flipped for the first time since 2019 on March 31, 2022. On March 29, 2022, the yield curve briefly reversed, albeit only briefly. The 2022 yield curve inversion predicts a recession by 2024 based on 50 years of data.
Bottom Line
The yield curve is a quick and accurate way to gauge investor sentiment on the likelihood of an economic downturn and stock market falls. It gives investors between six and eight months’ worth of notice, giving them plenty of time to make necessary adjustments to their holdings.
