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What is an inverted yield curve?
People may think bonds are boring – and often in a good way, as they’re considered fairly stable as investments go. But every once in a while, the market gets a little wild. Take the inverted yield curve: While the term itself may not sound exciting, when this phenomenon happens, financial experts, commentators and investors can’t stop talking about it.
In simple terms, an inverted yield curve tells us that the yields for short-term bonds maturing in two years or less have become higher than the yields on longer-term bonds that mature in five to 30 years.
Understanding an inverted yield curve
In a normal market environment, yields on short-term bonds tend to be lower than those of long-term bonds. Occasionally, this pattern can flatten or even reverse as investors grow more concerned about the near-term future of the economy, causing demand for seemingly less risky government bonds, like the 10-year U.S. Treasury, to surge. Historically, a prolonged inverted yield curve tends to be followed by a recession.
What creates an inverted yield curve?
The yield on bonds reflects investor demand, which rises and falls depending on people’s expectations for the future. When short-term yields rise higher than medium-or long-term yields, it’s typically because bond investors are reallocating money from equities and short-term bonds into longer-term bonds. As demand for long-term bonds climbs, their yields fall while the yield on short-term bonds rises to attract investors.
This can happen for a number of reasons, but it generally points to a sense that the economy might struggle at some point in the future and that central banks may need to lower interest rates to encourage businesses and individuals to borrow. When investors get worried, they tend to shift to government bonds, especially five and 10-year U.S. treasuries, because they’re seen as the less risky asset class.
Short-term bond rates typically don’t decline as quickly, as they’re more sensitive to central bank decisions to raise or lower interest rates.
How to read an inverted yield curve?
An inverted yield curve is seen as an early indicator of a possible recession. Historically, in the U.S., a recession tends to follow within a year after the curve inverts, but it’s not a perfect predictor. The perceived likelihood of recession increases the longer the yield curve stays inverted and the steeper the curve, indicating a greater spread between the yields on short and long bonds.
But there are differing ways to read an inverted yield curve. Some market participants consider the yield curve inverted when the yield on three-month U.S. Treasury bills exceeds that on 10-year T-bills. Others focus on the spread between two- and 10-year Treasuries. The lack of consensus on the exact definition of an inverted yield curve is one of the criticisms against its use as an economic indicator.
An inverted yield curve example
Two-year T-bills yielded more than 10-year bonds throughout most of 2006 after central banks dramatically slashed interest rates to shore up the economy. The Great Recession followed, beginning in December, 2007 and continued through 2009.
Historical significance of an inverted yield curve
All six U.S. recessions since 1978 were preceded by an inverted yield curve within the previous two years. However, the last one, in 2020, seems only tenuously linked to a brief inversion in August of 2019, before investors could have had any inkling of the COVID-19 pandemic to come, and not all inversions have been followed by recessions.
Example of an inverted yield curve indicating recession
The two-and-10 spread for U.S. Treasury bills turned negative in February, 2000. A recession followed 13 months later, beginning in March 2001.
Example of an inverted yield curve indicating no recession
The two-and-10 spread for T-bills inverted in 1965-66 without a recession ensuing. The same happened in 1998 as inflation rose in response to the Asian Financial Crisis, though some credit the U.S. Federal Reserve’s quick response for helping avert a recession.
Criticisms of the inverted yield curve as an indicator
What modern economists say about inverted yield curves?
Some economists argue that the unconventional monetary policy responses of central banks since the Global Financial Crisis of 2007-2009, such as quantitative easing, bond-buying and (in some markets) negative interest rates, have distorted the natural rhythms of the bond market and reduced the predictive power of an inverted yield curve.
Bond prices and yields are also affected by long-term fundamentals. Rising levels of government debt may increase the supply of bonds, while demographic trends may raise or lower the demand for bonds.
What can an inverted yield curve represent today?
How much faith to place in the inverted yield curve could depend on your belief in historical precedent. Every recession in modern history has been preceded by an inversion in the yield curve, however not every inversion has led to a recession. At its core, an inversion shows that bond investors are expecting a decline in longer-term rates, which are typically correlated with a recession.
Causes of an inverted yield curve
“As economists from the Federal Reserve Bank of Chicago wrote in a 2018 letter, “Many different variables determine the conditions and evolution of the economy, and the yield-curve slope summarizes them into a single indicator.” Its predictive power, in other words, comes from a number of component indicators that the yield curve reflects in aggregate.
Interest rates
Investors’ expectations for monetary policy play the single largest role in the shape of the yield curve. The pattern becomes inverted when the market expects the central bank to lower the overnight lending rate in the foreseeable future. The market consensus can of course turn out to be wrong, but the fact that it reflects the thinking of most market participants makes that less likely. And to a certain degree, a conservative mood in financial markets can influence the economy by curtailing companies’ and individuals’ access to capital. In that sense, an inverted yield curve can be a self-fulfilling prophecy.
Changes in investor sentiment
The shape of the yield curve also reflects market sentiment around the risks associated with different assets. A series of defaults in high-yield or emerging-market bonds, for example, might provoke a “flight to quality” that could affect yields on Treasury bills.
Cash rate
To maintain liquidity and satisfy regulatory requirements set by regulators, banks may often borrow money from each other overnight. The interest rate they charge is called the cash rate. Changes in the cash rate can shift the yield curve up or down, particularly for short-term bonds, sometimes referred to as the short end of the curve. A very low cash rate, as seen in most developed economies throughout the 2010s, decreases the likelihood of an inverted yield curve because central banks have less room to lower the overnight rate. When the cash rate rises – as it has since 2021 – the potential for interest rate cuts, and therefore an inverted yield curve, increases.
Inflation
The rate of inflation influences monetary policy at the same time that it helps determine investors’ real rate of return. Rising inflation both increases the likelihood that central banks will raise interest rates and boosts the yields required for bondholders to help earn a positive real rate of return. Expectations of disinflation (a drop in the rate of inflation) or deflation (which occurs when prices of goods and services drop) are one of the contributing factors to yield curve inversions.
What does this mean for investors?
Historically, prolonged inversions, like the one we are experiencing today have been followed by recessions most of the time, but not all of the time. Whether the same outcome will occur under the influence of current monetary policy and other factors could remain the subject of debate.
Regardless, an inverted yield curve is a cautionary sign for investors. Those with short time horizons or low tolerance for volatility could consider adopting a defensive posture, reducing their exposure to growth and cyclical stocks. Given that a yield curve inversion can be a sign of a struggling economy, some equity investors could consider focusing on quality stocks in low-volatility sectors such as consumer staples, telecoms and utilities. On the fixed income side, investors may use the inverted yield curve as a reason to reduce their average duration or ladder their bond maturities. They may also consider increasing their allocation to cash instruments, such as guaranteed investment certificates (GICs).
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