Inverted Yield Curve

What Is an Inverted Yield Curve?

An inverted yield curve represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality.

An inverted yield curve is sometimes referred to as a negative yield curve.

Understanding Inverted Yield Curve

The yield curve graphically represents yields on similar bonds across a variety of maturities. It is also known as the term structure of interest rates. A normal yield curve slopes upward, reflecting the fact that short-term interest rates are usually lower than long-term rates. That is a result of increased risk and liquidity premiums for long-term investments.

When the yield curve inverts, short-term interest rates become higher than long-term rates. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession. Because of the rarity of yield curve inversions, they typically draw attention from all parts of the financial world.

Historically, inversions of the yield curve have preceded recessions in the U.S. Due to this historical correlation, the yield curve is often seen as a way to predict the turning points of the business cycle. What an inverted yield curve really means is that most investors believe that short-term interest rates are going to fall sharply at some point in the future. As a practical matter, recessions usually cause interest rates to fall. Inverted yield curves are almost always followed by recessions.

An inverted Treasury yield curve is one of the most reliable leading indicators of an impending recession.

Special Considerations

Yield curves can be constructed for any type of debt instruments of comparable credit quality and different maturities. Some of the most commonly referred to yield curves are those that compare debt instruments that are as close to risk-free as possible in order to obtain as clear a signal as possible, uncomplicated by other factors that may influence a given class of debt. Usually, this means Treasury securities or rates associated with the Federal Reserve such as the fed funds rate. 

A true yield curve compares the rates on most or all maturities of a given type of instrument, presented as a range of numbers or a line graph. For example, the U.S. Treasury publishes a yield curve for its bills and bonds daily. For ease of interpretation, economists frequently use a simple spread between two yields to summarize a yield curve. The downside of using a simple spread is that it may only indicate a partial inversion between those two yields, as opposed to the shape of the overall yield curve. A partial inversion occurs when only some short-term bonds have higher yields than some long-term bonds.

Measuring Yield Curves

One of the most popular methods of measuring the yield curve is to use the spread between the yields of ten-year Treasuries and two-year Treasuries to determine if the yield curve is inverted. The Federal Reserve maintains a chart of this spread, and it is updated on most business days and is one of their most popularly downloaded data series.

The 10-year to two-year Treasury spread is one of the most reliable leading indicators of a recession within the following year. For as long as the Fed has published this data back to 1976, it has accurately predicted every declared recession in the U.S., and not given a single false positive signal. On Feb. 25, 2020, the spread dipped below zero, indicating an inverted yield curve and signaling a possible economic recession in the U.S. in 2020. 

Inverted Yield Curve. Image by Julie Bang © Investopedia 2019

Maturity Considerations

Yields are typically higher on fixed-income securities with longer maturity dates. Higher yields on longer-term securities are a result of the maturity risk premium. All other things being equal, the prices of bonds with longer maturities change more for any given interest rate change. That makes long-term bonds riskier, so investors usually have to be compensated for that risk with higher yields.

If an investor thinks that yields are headed down, it is logical to buy bonds with longer maturities. That way, the investor gets to keep today's higher interest rates. The price goes up as more investors buy long-term bonds, which drives yields down. When the yields for long-term bonds fall far enough, it produces an inverted yield curve.

Economic Considerations

The shape of the yield curve changes with the state of the economy. The normal or upward sloping yield curve occurs when the economy is growing. Two primary economic theories explain the shape of the yield curve; the pure expectations theory and the liquidity preference theory. 

In pure expectations theory, forward long-term rates are thought to be an average of expected short-term rates over the same total term of maturity. Liquidity preference theory points out that investors will demand a premium on the yield they receive in return for tying up liquidity in a longer-term bond. Together these theories explain the shape of the yield curve as a function of investors’ current preferences and future expectations and why, in normal times, the yield curve slopes upward to the right. 

During normal periods of economic growth, and especially when the economy is being stimulated by low interest rates driven by Fed monetary policy, the yield curve slopes upward both because investors demand a premium yield for longer-term bonds and because they expect that at some point in the future the Fed will have to raise short-term rates to avoid an overheated economy and/or runaway inflation. In these circumstances, both expectations and liquidity preference reinforce each other and both contribute to an upward sloping yield curve.

When signals of an overheated economy start to appear or when investors otherwise have reason to believe that a short-term rate hike by the Fed is imminent, then these theories begin to work in the opposite directions and the slope of the yield curve flattens and can even turn negative (and inverted) if this effect is strong enough.

Investors begin to expect that the Fed’s efforts to cool down the overheated economy by raising short-term rates will lead to a slowdown in economic activity, followed by a return to a low interest rate policy in order to fight the tendency for a slowdown to become a recession. Investors' expectation of falling short-term interest rates in the future leads to a decrease in long-term yields and an increase in short-term yields in the present, causing the yield curve to flatten or even invert.

It is perfectly rational to expect interest rates to fall during recessions. If there is a recession, then stocks become less attractive and might enter a bear market. That increases the demand for bonds, which raises their prices and reduces yields. The Federal Reserve also generally lowers short-term interest rates to stimulate the economy during recessions. That expectation makes long-term bonds more appealing, which further increases their prices and decreases yields in the months preceding a recession.

Historical Examples of Inverted Yield Curves

What Can Inverted Yield Curve Tell an Investor?

Historically, inversions of the yield curve have preceded recessions in the U.S. Due to this historical correlation, the yield curve is often seen as a way to predict the turning points of the business cycle. What an inverted yield curve really means is that most investors believe that short-term interest rates are going to fall sharply at some point in the future. As a practical matter, recessions usually cause interest rates to fall.

What Is a Yield Curve?

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. The slope of the yield curve gives an idea of future interest rate changes and economic activity. A normal yield curve slopes upward, reflecting the fact that short-term interest rates are usually lower than long-term rates, and is indicative of economic expansion. That is a result of increased risk and liquidity premiums for long-term investments.

Why Is the 10-Year to Two-Year Spread Important?

One of the most popular methods of measuring the yield curve is to use the spread between the yields of 10-year Treasuries and two-year Treasuries to determine if the yield curve is inverted. This spread is one of the most reliable leading indicators of a recession within the following year. For as long as the Fed has published this data (since 1976), it has accurately predicted every declared recession in the United States. On Feb. 25, 2020, the spread dipped below zero, indicating an inverted yield curve and signaling the possibility of an economic recession that, in fact, came to fruition in the U.S. in 2020. 

What Are Some Theories that Explain the Shape of the Yield Curve?

Two primary economic theories explain the shape of the yield curve; the pure expectations theory and the liquidity preference theory. In pure expectations theory, forward long-term rates are thought to be an average of expected short-term rates over the same total term of maturity. Liquidity preference theory points out that investors will demand a premium on the yield they receive in return for tying up liquidity in a longer-term bond. Together these theories explain the shape of the yield curve as a function of investors’ current preferences and future expectations and why, in normal times, the yield curve slopes upward to the right.