Inverted Yield Curve Meaning
The inverted yield curve is a graph that depicts long term debt instruments yielding fewer returns than the short term. It’s a rare phenomenon and usually precedes a financial breakdown. Hence also known as a predictor of crisis’, in fact, they are often seen as an accurate forecaster of a financial disaster because of the historical correlation between the two. The best example is the inversion of yield prior to the great financial crisis of 2007.
What’s a Normal Yield Curve?
The normal yield curve is a curve that depicts short term bond’s yielding lower returns as compared to long term bonds of the same class. The curve slopes in an upward fashion to indicate rising yields, as the investor expects higher compensation in the long run, which comes with higher uncertainties. Hence a rising curve, normal yield curve also called a positive yield curve.
Why the Curve Becomes Inverted?
Debt securities, by nature, are very sensitive to government policies and interest rates. While short term bonds are more reactive to interest rates as compared to long term bonds, long term bonds are more sensitive to inflation expectations in the economy as compared to shorter ones. Hence, the higher the expected inflation, the higher will be the yields as a result of investors demanding commensurate returns to offset inflation.
Therefore when fed raises interest rates, the yields go up, as investors might be attracted to other risky assets. however, when they see the inflation outlook in the long term is stable, they are inclined towards long term t bonds regardless of modest yields. This drives up the prices of long-term bonds further, thereby constantly reducing the yields.
Alternatively, as the economy begins to weaken and enters recession, investors are further attracted to long term treasury bonds to park their money in a safe haven against falling stock markets. As a direct result of high demand for the longer-term bond’s the yields begin to tumble, making the curve inverted.
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How does the Inverted Yield Curve Affect Investments?
An inverted yield hits the debt investors the most. It eats up the risk premium for long-term investors, letting them be better off in the shorter term. The spread between the treasury and other corporate debts narrows down, and therefore it makes sense to analyze and invest in the bond that offers lesser risk. In such a situation, treasury securities provide almost similar returns to the category of junk, albeit with lower risk.
As a matter of fact, as the curve inverts, the profit margin for banks and companies which leverage the near rate, by borrowing and then lending for long term rates, decline. However, inversion surprisingly also has a positive effect on a few stocks like those in food, oil, and other consumer durables, because investors tend to attract defensive stocks in case of downturns and these stocks are often the least affected.
Usually, long term bonds offer high yields. However, long term yields may go down as the general interest rates plummet. Regardless of their reinvestment risk, short term bonds give higher returns than longer-term securities in times of such downturns. The yield curve is highly reactive to the state of the economy.
A normal curve may hold on as long as the economy is growing; however, it may begin to diverge as the economic activity slows down. One of the major causes of this co-relation is how the market players think the capital investments are going to weigh in on the oncoming economic changes or stimulate the economy as a whole.
Yields are moved by the demand and supply factors in the economy. When the economy moves towards recession, and as the interest rates are on its way to the south, investors are more inclined towards long term securities to lock higher yields. As a result of increased demand for long-term securities, the prices go up, compelling the yields to go down. And as the demand for short-term securities goes down, its yields actually increase.
The inverted yield curve has been an occasionally unique phenomenon largely due to prolonged intervals between economic downturns since the 1990s. Inverted curves are an important part of economic cycles leading to downturns in the economy. They have historically rendered timely signals for economic changes, exhibiting the market’s opinions on the current economic scenario.
It is hard to outperform the market based only on fundamental knowledge. While nothing can be an accurate predictor of interest rate changes except the government itself, sagaciously tracking the yield movements can help investors anticipate near to mid-term changes in the economy. Therefore it’s important for investors to make prudent decisions by making the utmost use of valuable tools like yield curve.
This has been a guide to what is an inverted yield curve and its meaning. Here we discuss other types of the curve, why the curve becomes inverted, and how does it affect investments with a detailed explanation. You can learn more about excel modeling from the following articles –