What Is An Inverted Yield Curve?
What is a Yield Curve?
A yield curve is a line that plots yields (interest rates) of bonds of the same credit quality but differing maturities. The most closely watched yield curve is that for U.S. Treasury debt.
What is an Inverted Yield Curve?
An inverted yield curve illustrates that long-term interest rates are less than short-term interest rates. With an inverted yield curve, the yield decreases the farther away from the maturity date. Sometimes referred to as a negative yield curve, the inverted curve has proven in the past to be a reliable indicator of a recession.
Understanding Inverted Yield Curves
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. Analysts often distill yield curve signals to a spread between two maturities. This simplifies the task of interpreting a yield curve in which an inversion exists between some maturities but not others. The downside is that there is no general agreement as to which spread serves as the most reliable recession indicator.
Usually, the yield curve slopes upward, reflecting the fact that holders of longer-term debt have taken on more risk. A yield curve inverts when long-term interest rates drop below short-term rates, indicating that investors are moving money away from short-term bonds and into long-term ones. This suggests that the market as a whole is becoming more pessimistic about the economic prospects for the near future.
Such an inversion has served as a relatively reliable recession indicator in the modern era. Because yield curve inversions are relatively rare yet have often preceded recessions, they typically draw heavy scrutiny from financial market participants.
Conclusions on Inverted Yield Curves
Historically, protracted inversions of the yield curve have preceded recessions in the United States. An inverted yield curve reflects investors’ expectations for a decline in longer-term interest rates as a result of a deteriorating economic performance.
A yield curve that inverts for an extended period of time appears to be a more reliable recession signal than one that inverts briefly, whichever yield spread you use as a proxy. Fortunately, however, recessions are a rare enough event that we haven’t had enough to draw definitive conclusions.
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