What is an Inverted Yield Curve?
The term “inverted yield curve” refers to the situation wherein the short-term debt instruments generate a higher yield than the long-term debt instruments of the same credit quality, which is completely opposite to what happens in the normal scenario. The inverted yield curve is considered to be the leading indicator of an economic recession as statistics show that an inverted yield curve is invariably followed by a recession. The inverted yield curve is also popularly known as the negative yield curve.
Explanation of Inverted Yield Curve
The yield curve graphically represents the yields of similar bonds across different periods of maturity. It is also referred to as the term structure of interest rates. Normally, a yield curve is upward sloping that indicates that the long-term interest rates are higher than the short-term interest rates.
The normal yield curve is a reflection of the fact that investors usually consider long-term investments to be risky and so charge liquidity premium for that resulting in higher yield. However, at times the investment sentiments change and the investors tend to prefer long-term instruments over short-term investments, which is seen an indicator of economic recession in the near term. This when the yield curve inverts and the long-term interest rates become lower than the short-term interest rates.
Examples of Inverted Yield Curve
There have been several instances of inversion of the yield curve prior to the inception of an economic recession. Here, we will briefly discuss some of the instances that took place in the last two decades.
- In the year 1998, there was a brief inversion of the yield curve that continued for a few weeks during which the Treasury bond prices surged. The Fed then quickly intervened with some interest rate cuts to prevent a recession in the US. However, it is believed that the Fed’s actions may have catapulted the subsequent dotcom bubble in 2000.
- In the year 2006, the yield curve witnessed another inversion for the most part of the year. In fact, the long-term Treasury bonds outperformed the stocks during 2007 and soared in 2008 as the stock market plummeted. It marked the onset of the Great Recession of 2008.
- In the year 2019, there was another brief inversion of the yield curve. Subsequently, sings of inflationary pressure due to a tight labor market coupled with series of interest rate hikes by the Fed raised apprehensions of a recession, which forced the Fed to go back on its plan to increase interest rates. However, many experts believe it signaled the onset of the economic crisis of 2020, which has been further worsened by the outbreak of COVID-19.
Why the Yield Curve Inverts?
Inherently, debt investors are very reactive to changes in interest rates and government policies. While short-term bonds are more sensitive to changes in interest rates as compared to long-term bonds, long-term bonds are more reactive to inflationary expectations in an economy as compared to short-term bonds.
Therefore, instances of several rate cuts in a short span of time result in growing concerns in the market as the investor confidence drops. People tend to go for more secure long-term investments resulting in increased price (or reduced yield), while they avoid short-term investments pushing their yield high. In this way the yield of the long-term bonds drops below that of the short-term bonds leading to an inverted yield curve.
Causes of the Inverted Yield Curve
As can be seen from the previous section, the primary causes of an inverted yield curve are:
- Frequent change in interest rates
- Expectation of stability in the long run
- Weakening economy
- Low market confidence
Inverted Yield Curve Interest Rates
The bond yield in the US saw a major decline since July 2019 which further worsened with the outbreak of COVID-19 resulting in weak investor sentiments. As such, we saw an inversion of the yield curve during March 2020 (as can be seen in the below graph) as people expected to sever impacts of the ongoing pandemic in the near term. In a declining interest rate scenario, investors started to resort to long-term Treasury bonds and hence the yield curve inverted. In the below graph, we can see that the blue yield is from March 2019 and is a normal yield curve, while the orange one is from March 2020 and represents an inverted yield curve. However, the good news is that the scenario has improved since then.
|Date||1 Mo||2 Mo||3 Mo||6 Mo||1 Yr||2 Yr|
How does an Inverted Yield Curve Predict Recession?
Historically, most of the inversions in the yield curve in the US have been followed by a recession. As such, the inversion in the yield curve is seen as a leading indicator to predict the turning point in the business cycle. Basically, an inverted yield curve indicates that most of the investors believe that the economy is weakening and is about to go into recession. Consequently, they are attracted to stable long-term treasury bonds as a safe haven for parking their money in a crashing stock market environment. Given the high demand for long-term bonds, their yield begins to drop resulting in an inverted curve.
Impact of Inverted Yield Curve
Some of the major impacts of the inverted yield curve are as follows:
- It almost entirely wipes out the risk premium from long-term investments.
- The spread between treasury bonds and other corporate bonds narrows down.
- The profit margins for banks and companies decline significantly.
- Investment in essential commodities increases as they are least expected to be impacted by the recession.
This is a guide to Inverted Yield Curve. Here we also discuss the introduction and causes of the inverted yield curve along with impacts and examples. You may also have a look at the following articles to learn more –