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Inverted Yield Curve

Updated on April 26, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Inverted Yield Curve Meaning

The inverted yield curve is a graph that depicts long-term debt instruments yielding fewer returns than short-term. It’s a rare phenomenon and usually precedes a financial breakdown. The best example is the inversion of yield before the great financial crisis of 2007. Hence also known as predictors of crisis; in fact, they are often seen as accurate forecasters of a financial disaster because of the historical correlation between the two.

Inverted Yield Curve meaning

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It is hard to outperform the market based only on fundamental knowledge. Therefore, investors need to make prudent decisions by using valuable tools like the yield curve. While nothing can accurately predict interest rate changes except the government itself, sagaciously tracking the yield movements can help investors anticipate near to mid-term changes in the economy.

Key Takeaways

  • The “inverted yield curve” signifies a scenario where long-term debt instruments offer lower returns than short-term ones. This phenomenon is rare and often precedes financial crises, as seen in the lead-up to the Great Financial Crisis of 2007. Consequently, it’s often referred to as a predictor of crises.
  • Due to their historical correlation, inverted yield curves are frequently considered reliable indicators of impending financial disasters.
  • The economy’s state significantly influences the yield curve’s shape. While long-term bonds may sometimes yield higher returns, they can experience reduced returns if overall interest rates rise.

Inverted Yield Curve Explained

The inverted yield curve chart is a graphical representation of the fact that sometimes, the yield of short-term debt instruments or bonds are higher than the long-term ones. It is also called negative yield curve.

The normal yield curveYield CurveThe Yield Curve Slope is used to estimate the interest rates and changes in economic activities. It is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis).read more 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, a normal yield curve, is also called a positive yield curveA Positive Yield CurveA normal yield curve refers to a positive yield curve formed when the long-term debt instruments provide greater returns when compared to the short-term debt instruments when both these options possess equivalent credit risk and quality.read more.

But in this yield curve becomes inverted, it suggests that the economy is portraying a pessimistic situation where the inverted yield curve bonds project a possibility of recession.

Inverted Yield Curve

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The inverted yield curve chart is an important part of economic cycles leading to economic downturns. They have historically rendered timely signals for economic changes, exhibiting the market’s opinions on the current economic scenario. The inverted yield curve has been a unique phenomenon largely due to prolonged periods between economic downturns since the 1990s.

Yields are moved by the demand and supply factors in the economy. When the economy moves towards recession and the interest rates are on their way to the south, investors are more inclined toward long-term securities to lock in higher yields. As a result of increased demand for long-term securities, the prices go up, compelling the yields to go down, showing inverted yield curve bonds. And as the demand for short-term securities goes down, their yields increase.

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Causes

Now let us analyse some of the causes that may make the yield curve inverted. 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 investmentsThe Major Causes Of This Co-relation Is How The Market Players Think The Capital InvestmentsCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more are going to weigh in on the oncoming economic changes or stimulate the economy as a whole.

Examples

The yield curve is highly reactive to the state of the economy where it is important to understand the inverted yield curve recession prediction. Usually, long-term bonds offer high yields. However, long-term yields may go down as the general interest rates plummet. Short-term bonds give higher returns than longer-term securities in such downturns regardless of their reinvestment risk.

However, let us understand the situation through some examples.

The yield curve inversion scenario is unwinding in the bond market which is a preeminent and important indicator of coming recession. It has been accounted that the yield of the 10-year Treasury bond is currently below the two-year yield by roughly 0.56 percent.

The US treasury yield is a very dependable benchmark for economic forecast for all investors. There is a good reason behind it. This yield curve inversion has done a perfect recession forecast 10 times since 1955, as per the information revealed by the Federal Reserve Bank.

Impact

Let us understand the inverted yield curve investment strategy. An inverted yield hits the debt investors the most. It eats up the risk premiumRisk PremiumRisk Premium, also known as Default Risk Premium, is the expected rate of return that the investors receive for their high-risk investment. You can calculate it by deducting the Risk-Free Investment Return from the Actual Investment Return. read more for long-term investors, making them better off in the shorter term. The spread between the treasury and other corporate debts narrows down; therefore, it makes sense to analyze and invest in a bond that offers lesser risk. In such a situation, treasury securities provide similar returns to the junk category, albeit with lower risk.

As the curve inverts, the profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more for banks and companies, which leverage the near rate by borrowing and then lending for long-term rates, declines. However, surprisingly, inversion also positively affects a few stocks, like those in food, oil, and other consumer durables. Investors tend to attract defensive stocksDefensive StocksA Defensive Stock is a stock that provides steady growth and earnings to the investors in the form of dividends irrespective of the state of the economy as it has a low correlation with the overall stock market/economy and is therefore insulated from changing business cycles.read more in case of downturns, which are often the least affected.

Inverted Yield Curve Vs Normal Yield Curve

The two curves show two different scenarios while establishing the relationship between the the yields of short-trm and long-term bonds. Let us compare them and find the differences.

  • The former shows that the shorter term bonds offer higher yields than the longer ones, whereas the latter shows that the longer term bonds offer more yields than the shorter ones.
  • The inverted yield curve recession prediction portrays a negative or pessimistic market outlook whereas the latter portrays a positive economic condition.
  • The former indicates a low inflation or recession level, whereas the latter suggests higher inflation.
  • The former implies that investors are ready to accept lower return on longer term bonds because they are giving more priority to safety of investments, whereas the latter implies that investors want high returns as a compensation for higher risk on long term bonds.
  • The graph of the former is flatter or downward sloping, indicating a negative market expectation or potential fall in interest rates or economic weakness, but the latter shows a steeper upward sloping curve indicating a positive expectation of the market regarding rise in interest rates.

However, it is important to understand that the negatively sloping yield curve does not guarantee a inverted yield curve investment strategy but is it a useful predictor as shown in the history or any economy. There may be a difference between the time gap between the curve inversion and actual economic slowdown but it can be used to assess the economic health of a country.

Frequently Asked Questions (FAQs)

1. Is an inverted yield curve bullish or bearish? 

An inverted yield curve is typically considered a bearish signal for the economy and financial markets. It occurs when short-term interest rates are higher than long-term rates, often preceding economic downturns or recessions.

2. What is the importance of understanding an inverted yield curve? 

Understanding an inverted yield curve is crucial as it serves as a potential predictor of economic recessions. It indicates investor expectations of future economic weakness and can influence decisions by businesses, investors, and policymakers regarding investments, borrowing, and monetary policy adjustments.

3. How long will the inverted yield curve last? 

The duration of an inverted yield curve’s persistence can vary widely. It’s impossible to predict precisely how long it will last, as it depends on various economic factors, policy responses, and market sentiment. In some cases, an inverted yield curve may signal a relatively short-term economic slowdown, while in other instances, it could indicate a more prolonged downturn.

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