What is an Inverted Yield Curve?

Long-term interest rates are lower than short-term interest rates when the Inverted yield curve is reversed. When the yield curve is reversed, the yield decreases as the maturity date gets farther away. Inversion of the yield curve, also sometimes called a negative yield curve, has been a good sign of a decline in the past.

How to Understand Inverted Yield Curves

The yield curve is a graph that shows the returns on similar bonds with different maturities. It’s also called the time structure of interest rates. For instance, the U.S. Treasury posts daily returns on Treasury bills and bonds that can be shown on a graph as a curve.

A spread between two dates is often all that analysts need to see in the yield curve. This makes it easier to understand a yield curve where some periods have an inversion, and others do not. The bad thing is that most people disagree on which spread is the best way to tell if a recession is coming.

The yield curve usually goes up, which shows that people who own longer-term debt are taking on more risk.

When long-term interest rates fall below short-term rates, the yield curve inverts. This means investors are changing their money from short-term to long-term bonds. In other words, the market is losing faith in the economy.

This kind of inversion has recently been an excellent way to tell when a recession is coming. Since yield curve inversions aren’t very common but have often come before recessions, people in the financial markets pay close attention to them.

One of the most accurate signs that a recession is coming is a Treasury yield curve that has turned negative.

Pick Your Spread

Researchers who study the link between an inverted yield curve and recessions have mostly looked at the difference in yields between the 10-year U.S. Treasury bond and the three-month Treasury bill. On the other hand, market participants have mostly looked at the difference in yields between the 10-year and two-year bonds.

Federal Reserve Chair Jerome Powell said in March 2022 that he likes to look at the difference between the current rate on three-month Treasury bills and the futures prices that predict the same rate 18 months from now to determine the risk of a recession.

Examples of Inverted Yield Curves in the Past

Since it gave a false positive in the mid-1960s, the 10-year to two-year Treasury spread has been an excellent way to predict a recession. 8 That hasn’t stopped many top U.S. economic leaders from doubting its ability to predict the future over the years.

Following Russia’s failure on its debt in 1998, the 10-year/two-year spread briefly went the other way. Due to quick interest rate cuts by the Federal Reserve, the United States did not go into a recession.

In the last few decades, a flattened yield curve has often come before recessions, but it does not cause them. Instead, bond prices show how much buyers think longer-term yields will decrease, usually during a recession.

For most of 2006, the spread went negative. In 2007, long-term Treasury bonds did better than stocks. In December 2007, the Great Recession began.

As of August 28, 2019, the 10-year/two-year range went down briefly. Because of the COVID-19 pandemic, the U.S. economy went into a two-month slowdown in February and March 2020. This could not have been a factor in bond prices six months earlier.

Does the fact that the yield curve is inverted today mean that a recession is coming?

The yield curve reversed again at the end of 2022, when inflation rose quickly.

These were the Treasury rates on December 4, 2023:

The yield on a three-month Treasury note is 4.31%

The yield on a two-year Treasury note is 4.56%

Rate on a 10-year Treasury note: 4.22%

The 30-year Treasury rate is 4.4%.

As you can see above, the 10-year U.S. Treasury rate is 0.26 percentage points less than the two-year yield. From 2022 to now, the inverted yield curve has shrunk but is still inverted.

When buyers look at the yield curve, it shows how they feel about the economy and whether the Fed will keep raising interest rates. Maybe not.

Many experts think that the U.S. economy might still be going down. Some people, though, think that the fact that the concave yield curve is getting more minor as of December 2023 tells a different story. Some people say that the yield curve might not be a sign of trouble in the economy but that investors are sure that rising prices have been contained and that things will return to normal.

What does a yield curve mean?

A line shows the yields (interest rates) of bonds with different maturities but the same credit rating. This is called a yield curve. The U.S. Treasury paper yield curve is the one that people pay the most attention to.

What does an upside-down yield curve tell an investor?

In the past, long-lasting yield curve inversions have happened before U.S. recessions. When the yield curve is reversed, investors think longer-term interest rates will go down because the economy is worsening.

What’s the point of the 10-year to 2-year spread?

Many investors use the difference in yields between 10-year and two-year U.S. Treasury bonds as a stand-in for the yield curve and has been a pretty good early warning sign of a recession in recent years. Some Federal Reserve officials have said that looking at shorter-term payments gives us more information about the likelihood of a recession.

Conclusion

• The yield curve is a graph that shows the returns on similar bonds with different maturities.
• When short-term debt instruments have higher rates than long-term ones with the same credit risk, the yield curve is “inverted.”
• An inverted yield curve is not standard. It shows that bond buyers think longer-term interest rates will decrease, usually during recessions.
• Market participants and analysts use several yield spreads to stand in for the yield curve.