The Impact of an Inverted Yield Curve

The yield curve shows the difference in the short- and long-term interest rates of bonds and other fixed-income securities issued by the U.S. Treasury. An inverted yield curve occurs when short-term interest rates exceed long-term rates.

An inverted yield curve is a noteworthy and uncommon event. Under normal circumstances, the yield curve is not inverted. Debt with longer maturities typically pay higher interest rates than nearer-term ones.

From an economic perspective, an inverted yield curve suggests that the near term is riskier than the long term.

Key Takeaways

• A yield curve illustrates the interest rates on bonds of increasing maturities.
• An inverted yield curve occurs when short-term debt instruments carry higher yields than long-term instruments of the same credit risk profile.
• Inverted yield curves are unusual since longer-term debt should carry greater risk and higher interest rates, so when they occur there are implications for consumers and investors alike.
• An inverted Treasury yield curve is one of the most reliable leading indicators of an impending recession.

Interest Rates and Yield Curves

Typically, short-term interest rates are lower than long-term rates. The yield curve slopes upwards, reflecting higher yields for longer-term investments. This is referred to as a normal yield curve.

When the spread between short-term and long-term interest rates narrows, the yield curve begins to flatten. A flat yield curve can be a transition from a normal yield curve to an inverted one.

What Does an Inverted Yield Curve Suggest?

Historically, an inverted yield curve has been viewed as an indicator of a pending economic recession. When short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall.

More recently, this viewpoint has been called into question, as foreign purchases of securities issued by the U.S. Treasury have created a high and sustained level of demand for products backed by U.S. government debt.

When investors are aggressively seeking debt instruments, the debtor can offer lower interest rates. When this occurs, many argue that it is the law of supply and demand, rather than impending economic doom that allows lenders to attract buyers without paying higher interest rates.

Inverted yield curves have been relatively rare, due in large part to longer-than-average periods between recessions since the early 1990s. For example, the economic expansions that began in March 1991, November 2001, and June 2009 were three of the four longest economic expansions since World War II.

During these long periods, the question often arises as to whether an inverted yield curve can happen again.

Economic cycles, regardless of their length, have historically transitioned from growth to recession and back again. Inverted yield curves are an essential element of these cycles, preceding every recession since 1956.

Upward-sloping yield curves are a natural extension of the higher risks associated with long maturities. In a growing economy, investors demand higher yields at the long end of the curve to compensate for the opportunity cost of investing in bonds versus other asset classes like stocks, and to maintain an acceptable level over inflation rates.

As an economic cycle begins to slow, the upward slope of the yield curve tends to flatten as short-term rates increase and longer yields stay stable or decline slightly. In this environment, investors see long-term yields as an acceptable substitute for the likelihood of lower returns in stocks and other asset classes, which tend to increase bond prices and reduce yields.

The Formation of an Inverted Yield Curve

As concerns of an impending recession increase, investors tend to buy long Treasury bonds as a safe harbor from falling equities markets. As a result of this rotation to long maturities, yields can fall below short-term rates, forming an inverted yield curve.

Since 1955, equities have peaked six times after the start of an inversion, and the economy has fallen into recession within six to 24 months.

An inverted yield curve appeared in August 2006, as the Fed raised short-term interest rates in response to overheating equity, real estate, and mortgage markets. The inversion of the yield curve preceded the peak of the Standard & Poor’s 500 in October 2007 by 14 months and the official start of the recession in December 2007 by 16 months.

In 2019, the yield curve again inverted, worrying economists about another downturn. In early 2020, the COVID-19 pandemic did indeed trigger a global recession. No one thought it was likely that the yield curve was able to predict the pandemic. In any case, the COVID-19 downturn quickly rebounded to new record highs.

Inverted Yield Curve Impact on Consumers

An inverted yield curve has an impact on consumers.

Homebuyers financing their properties with adjustable-rate mortgages (ARMs) have interest-rate schedules that are periodically updated based on short-term interest rates. When short-term rates are higher than long-term rates, payments on ARMs rise. When this occurs, fixed-rate loans can be more attractive than adjustable-rate loans.

Lines of credit are also affected. Consumers must dedicate a larger portion of their incomes toward servicing existing debt. This reduces expendable income and has a negative effect on the economy as a whole.

Inverted Yield Curve Impact on Fixed-Income Investors

A yield curve inversion has the greatest impact on fixed-income investors.

In normal circumstances, long-term investments have higher yields. Because investors are risking their money for longer periods of time, they are rewarded with higher payouts. An inverted curve eliminates the risk premium for long-term investments, giving investors better returns with short-term investments.

When the spread between U.S. Treasuries (a risk-free investment) and higher-risk corporate alternatives is at historical lows, it is often an easy decision to invest in lower-risk vehicles. In such cases, purchasing a Treasury-backed security provides a yield similar to the yield on junk bonds, corporate bonds, real estate investment trusts (REITs), and other debt instruments, but without the risk inherent in these vehicles.

Money market funds and certificates of deposit (CDs) may also be attractive – particularly when a one-year CD is paying yields comparable to those on a 10-year Treasury bond.

Inverted Yield Curve Impact on Stock Investors

When the yield curve becomes inverted, profit margins fall for companies that borrow cash at short-term rates and lend at long-term rates, such as community banks. Likewise, hedge funds are often forced to take on increased risk to achieve their desired level of returns.

In fact, a bad bet on Russian interest rates is largely credited for the demise of Long-Term Capital Management, a well-known hedge fund run by bond trader John Meriwether.

Despite their consequences for some parties, yield-curve inversions tend to have less impact on consumer staples and healthcare companies, which are not interest-rate dependent.

This relationship becomes clear when an inverted yield curve precedes a recession. When this occurs, investors tend to turn to defensive stocks, such as those in the food, oil, and tobacco industries, which are often less affected by downturns in the economy.

• In 2019, the yield curve briefly inverted. Signals of inflationary pressure from a tight labor market and a series of interest rate hikes by the Federal Reserve from 2017 to 2019 raised expectations of a recession. Those expectations eventually led the Fed to walk back the interest rate increases. The start of the COVID-19 pandemic, in the Spring of 2020, did lead to a brief recession.
• In 2006, the yield curve was inverted during much of the year. Long-term Treasury bonds went on to outperform stocks during 2007. In 2008, long-term Treasuries soared as the stock market crashed. In this case, the Great Recession arrived and turned out to be worse than expected.
• In 1998, the yield curve briefly inverted. For a few weeks, Treasury bond prices surged after the Russian debt default. Quick interest rate cuts by the Federal Reserve helped to prevent a recession in the United States. However, the Fed’s actions may have contributed to the subsequent dotcom bubble.

What Economic Theories Describe the Yield Curve?

Two economic theories have been used to explain the shape of the yield curve; the pure expectations theory and the liquidity preference theory.

• Pure expectations theory posits that long-term rates are simply an aggregated average of expected short-term rates over time.
• Liquidity preference theory suggests that longer-term bonds tie up money for a longer time and investors must be compensated for this lack of liquidity with higher yields.

When Was the Last time the Yield Curve Was Inverted?

The yield curve inverted on March 31, 2022, when the two-year yield rose above the 10-year yield.

The inversion followed shortly after the Federal Open Markets Committee began raising the target federal funds rate to control inflation. The trend peaked in July 2023 after a series of interest rate hikes by the Federal Reserve.

How Well Do Inverted Yield Curves Predict a Recession?

An inverted yield curve in U.S. Treasuries has predicted every recession since 1955, with only one false signal during that time.

 It even “predicted” the economic downturn that followed the COVID-19 pandemic (although most economists attribute this to luck, and not the fact that it can predict natural disasters).

The Bottom Line

The inverted yield curve has a solid history of predicting a recession. Like many other economic indicators, it’s unwise to bet the farm on it.

If you want to be a smart investor, ignore the noise. Instead of spending time and effort trying to figure out what the future will bring, construct your portfolio based on long-term thinking and long-term convictions, not short-term market movements.

For your short-term income needs, do the obvious: choose the investment with the highest yield, but keep in mind that inversions are an anomaly and they don’t last forever. When the inversion ends, adjust your portfolio accordingly.

Read the original article on Investopedia.