Last Updated on 7 September, 2021 by Samuelsson
If you are conversant with financial news, you may have heard about the yield curve and the inversion of the yield curve and probably don’t know what they mean. While the term yield curve refers to the relationship between the interest rates of debt instruments and their maturity periods, what does an inverted yield curve mean?
An inverted yield curve, also known as a negative yield curve, refers to a situation where a long-term debt instrument has a lower yield than a short-term debt instrument of the same credit quality. It is an abnormal situation that often indicates a deterioration in the economy and an impending crisis in the equity market.
You will obviously want to know why the yield curve can be inverted and its impact on the markets, which is why we will discuss the topic under the following headings:
- What is an inverted yield curve?
- Understanding inverted yield curve: what does it mean?
- Why does the yield curve invert?
- The impact of yield curve inversion: what does an inverted yield curve tell you?
- Factors to consider when interpreting an inverted yield curve
- Historical examples of inverted yield curves
What is an inverted yield curve?
An inverted yield curve is a type of yield curve that occurs when the yields on bonds with a shorter maturity period are higher than the yields on bonds (from the same issuer) with a longer maturity period. It is used to represent a situation where long-term debt instruments have lower yields than short-term debt instruments of the same credit quality.
The yield curve (also known as the term structure of interest rates), as you may already know, is a graphical representation of yields on bonds of the same credit quality across a variety of maturities. In the normal yield curve, the short-term bills yield less than the long-term bonds because investors expect a lower return when their money is tied up for a shorter period and a higher return when their money is tied up for a longer period. Hence, the normal yield curve slopes upward, reflecting the fact that the longer the maturity period, the higher the yield, owing to increased risk and liquidity premiums for long-term investments.
However, when the yield curve inverts, it shows that short-term interest rates have become higher than long-term rates. The inverted yield curve is sometimes referred to as a negative yield curve because it represents an abnormal situation in the economy. It is the rarest of the three main curve types and is considered to be a predictor of economic recession or, at least, a potentially significant downturn in the equity market.
Owing to the rarity of this type of yield curve, it typically draws attention from all parts of the financial world. The yield curve inversion shows that investors have little confidence in the near-term economy, so they demand more yield for a short-term bond than for a long-term one because they believe that the near-term is riskier than the distant future. They would prefer to buy long-term bonds and tie up their money for years even if they receive lower yields so as to avoid equity investment during that period of bad economic situation.
Understanding inverted yield curve: what does it mean?
The yield curve is a graph plotted with the bond yield rate on the vertical section and the maturity periods on the horizontal section. Some graphs may use the bond’s interest rate, instead of the yield rate, which is actually the current annual interest relative to the current price of the bond. While yield curves can be constructed for any type of debt instruments of comparable credit quality and different maturities, the yield curve that matters to the investment world is one that compares the yield rate of the government bonds, such as the U.S. Treasury bonds, to their various maturity periods as you can see in the graph below
As you can see, the picture above is that of a normal yield curve, as the curve slopes upward showing that longer-term maturities offer a higher yield than shorter-term ones. This is what is expected when the economy is in good shape — investors get rewarded with higher yields for long-term investments.
On the other hand, the graph below shows an inverted yield curve. It is inverted because the slope is pointing downwards, rather than upward as is the case with the normal curve. What this means is that longer-term bonds offer lower yield rates than shorter-term bonds.
The implication of an inverted yield curve is that economy of the country whose government bonds were used in constructing the curve is not doing well at that period. Most times, it signifies an impending recession.
For example, in the US, an inverted yield curve of U.S. Treasury yields shows that the yields on short-term Treasury bills, notes, and bonds are higher than those of long-term versions. It indicates an impending crisis in the U.S. economy since investors prefer longer-term bonds that can tie up their cash for a long time to shorter-term bills that would leave them with free cash in a short while.
Usually, the U.S. Treasury Department sells their debt instruments in 12 maturities, but they are often grouped in three categories as follows:
- Treasury Bills: There are five maturities in this group, which are 4, 8, 13, 26, and 52 weeks.
- Treasury Notes: T-notes mature in 2, 3, 5, 7, or 10 years.
- Treasury Bonds: There are only 20-year and 30-year Treasury bonds.
The U.S. Treasury publishes a yield curve for its debt instruments daily. When an inverted yield curve forms, it means investors believe they are better off holding onto a longer-term Treasury than a short-term one. With a short-term bill, the investors will have to reinvest that money after a few months. So, since they believe a recession is coming, they expect the value of the short-term bills to fall soon when the Federal Reserve lowers the Fed funds rate to stimulate the economy — short-term Treasury bill yields track the fed funds rate — so they abandon those short-term bills, thereby lowering the price of their prices and increasing their yield.
To make the curve easier to interpret, economists often use a simple spread that compares the yields of two maturity periods, but this only indicates a partial inversion between those two yields, as opposed to the shape of the overall yield curve. It is called a partial inversion if only some short-term bonds have higher yields than some long-term bonds.
Most times, analysts use the spread between the yields of ten-year Treasuries and two-year Treasuries to determine if the yield curve is inverted. Interestingly, the Federal Reserve maintains a chart of this spread and updates it on most business days. In fact, this ten-year/two-year Treasury spread is one of the most reliable leading indicators of a recession within the following year. The Fed started publishing the data in 1976, and since then, it accurately predicted every declared recession in the US, without any single false positive signal. It predicted the 2020 pandemic-induced recession when, on February 25, 2020, it dipped below zero, indicating an inverted yield curve.
Why does the yield curve invert?
Now, you know what a yield curve and an inverted yield curve are, but why does the yield curve invert? Or, to put it more directly, why will a short-term Treasury bill have a higher yield than a longer-term counterpart? Well, here’s what happens:
When investors are expecting an imminent downturn in the economy, they flock to longer-term Treasury notes and bonds where they can put their money away until the economy recovers. Short-term Treasury bills won’t appear attractive to them as that would mean having to worry about reinvesting their cash in a few months’ time when the short-term securities mature.
As a result of this preference, the demand for Treasury notes and bonds rises, while that of Treasury bills falls. The increasing demand for T-notes and T-bonds causes their prices to go up, and if we assume a stable coupon rate (interest rate), their yields fall as the prices go up — the yield is the return of the coupon rate relative to the current bond price. For the Treasury bills, on the other hand, the low demand causes the prices to decline, thereby increasing the yield.
With the yields of short-term Treasury bills increasing and those of longer-term T-notes and T-bonds decreasing, the yield curve becomes inverted — that is, it assumes a downward slope. The picture below compares the graph of the normal yield curve to the inverted yield curve.
Another way to look at the yield inversion is this: On average, recessions last 10 months, so when investors are expecting an impending recession, they will want to channel their capital to investments that can offer them safety for at least two years. As a result, they may avoid any Treasury security with maturities of less than two years. Short-term Treasury bills will, therefore, need to pay a higher yield to attract investors, while longer-term T-notes and T-bonds don’t need as high of a yield to attract investors.
The impact of yield curve inversion: what does an inverted yield curve tell you?
An inverted yield curve is usually taken as an indicator of an impending economic recession. Furthermore, with short-term interest rates exceeding long-term rates, the inverted yield curve suggests that the market sentiment shows a poor long-term outlook and the yields offered by long-term fixed income will continue to fall. Of course, the impact of the economic situation indicated by the yield curve inversion varies among different participants in the economy. Let’s take a look at the impact on fixed-income investors, equity investors, and consumers.
The impact of an inverted yield curve on fixed-income investors
The impact of the yield curve inversion is primarily felt by fixed-income investors because the curve is primarily based on fixed-income investments. When the economy is in good shape, as depicted by a normal yield curve, long-term investments offer higher yields as a reward for risking your money for longer periods.
However, when the yield curve inverts, the premium reward for long-term investments is no longer there, yet investors still prefer them because they want to protect their capital from an impending economic crisis. Owing to the preference for longer-term bonds, the shorter-term versions become a lot cheaper wither higher returns to attract investors.
So, the decision on where to invest comes down to what the investor wants, but it’s not the same when comparing other fixed-income securities. When the spread between higher-risk corporate bonds and U.S. Treasuries (which is considered a risk-free investment) is at historical lows, it is easy to choose to invest in Treasury instrument since it is cheap at that period. During such periods, owing to its low prices, Treasury-backed securities would offer yields similar to what you get on corporate bonds, real estate investment trusts (REITs), junk bonds, and other debt instruments — but without the risk inherent in these vehicles. Additionally, if a one-year CD yields are comparable to those on a 10-year Treasury bond, certificates of deposit (CDs) and money market funds may be attractive options.
The impact of an inverted yield curve on equity investors
In the equity market, the impact of an inverted yield curve varies with the market sector and industry. For companies in the financial sector, especially companies like community banks that borrow cash at short-term rates and lend at long-term rates, the inversion of the yield curve will lead to a decline in profit margins.
In the same way, hedge funds and investors that trade on margin will be forced to take on increased risk so as to achieve their desired level of returns when there is a yield curve inversion because of the rising interest on short-term loans. A popular example is the demise of Long-Term Capital Management, a well-known hedge fund run by bond trader John Meriwether, following a bad bet on Russian interest rates.
However, the impact of yield curve inversion is less severe on companies in the consumer staples and health care sectors, which don’t usually depend on interest rates. This is why such companies are not usually badly hurt during a recession. Since yield curve inversion normally precedes a recession, when it forms, investors tend to turn to defensive stocks, such as those in the food, health care, tobacco, and utilities, which are often less affected by downturns in the economy.
The impact of an inverted yield curve on consumers
Apart from its impact on both fixed-income and equity investors, the inversion of the yield curve also has an impact on consumers. The impact is particularly seen when short-term interest rates are necessary to get the required products and services.
A good example is in the case of homebuyers financing their properties with adjustable-rate mortgages (ARMs). Since their interest-rate schedules are periodically updated based on short-term interest rates, if short-term rates are higher than long-term rates, payments on ARMs tend to rise. In this situation, fixed-rate loans may seem better than adjustable-rate loans.
Of course, lines of credit are also affected the same way. But whatever the case, the key thing is that consumers have to dedicate a larger portion of their incomes toward servicing existing debts, which reduces their expendable income and leads to a negative effect on the economy as a whole.
Historical examples of inverted yield curves
There have been many yield curve inversions since the Fed started maintaining the yield curve charts in 1976; however, we will focus on the few recent ones:
The 1998 yield curve inversion
Back in 1998, the yield curve inverted briefly, with Treasury bond prices surging for a few weeks following a debt default by the Russian government. To avert the impending recession in the US, the Federal Reserve made quick interest rate cuts, but this Fed’s actions seemed to have contributed to the subsequent frenzy in the equity market, which was dubbed the dotcom bubble. Eventually, the recession hit and hit very hard at the turn of the millennium.
The 2006 yield curve inversion
Before the 2007/2008 financial market crisis, the yield curve was inverted for most of 2006, and by 2007, long-term Treasury bonds were even outperforming stocks in capital appreciation. Getting into 2008, long-term Treasuries were soaring when the stock market crashed. What followed was the Great Recession, which turned out to be worse than anyone could have imagined.
The 2019/2020 yield curve inversion
The most recent yield curve inversions happened in late 2019 and early 2020. On August 12, 2019, the 10-year yield fell to 1.65%, hitting a three-year low. At that time, the 1-year note yield was 1.75%, so there’s a partial inversion on the cards. By August 15, the yield on the 30-year bond closed below 2% for the first time ever, triggering investors to rush to Treasury-based instruments. However, the Fed reversed its position and lowered the rate a bit, putting an end to a series of interest rate hike it embarked on in 2017.
However, the yield curve inversion started again on Feb. 14, 2020, with the yield on the 10-year note falling to 1.59% when the yield on the one-month and two-month bills had risen to 1.60%. As at that time, investors were already getting concerned about the COVID-19 pandemic. By March 9, the 10-year note had fallen to a record low of 0.54%, and the equity market was already in a free fall.