Inverted Yield Curve

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 curveYield CurveA yield curve 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). The slope of the yield curve provides an estimate of expected interest rate fluctuations in the future and the level of economic activity. 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, normal yield curve 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.

Inverted Yield Curve

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Why the Curve Becomes Inverted?

Inverted Yield Curve Example

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 inflationExpected InflationInflation expectations refer to the opinion on the future inflation rate from different sections of the society, such as investors, bankers, central banks, workers, and business owners. As a result, they take this rate into account when making decisions about various economic activities they want to engage in in the future.read more, 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.

How does the Inverted Yield Curve Affect Investments?

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, 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 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, 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 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 and these stocks are often the least affected.

Important Note

Usually, long term bonds offer high yields. However, long term yields may go down as the general interest rates plummet. Regardless of their reinvestment riskReinvestment RiskReinvestment risk refers to the possibility of failing to induce the profits earned or cash flows into the same scheme, financial product or investment. It even states the uncertainty of not getting the similar returns when such funds are invested in a new investment opportunity.read more, 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 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.

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.

Bottom Line

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.

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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 –

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