Inverted Yield Curve
Candlefocus EditorAn inverted yield curve occurs when short-term debt instruments have higher yields than long-term instruments of the same credit risk profile. Due to the increasing maturity, it is expected that the yields should increase; the inversion happens when this assumption is violated. This can be easily visible on a yield curve graph, where instead of the normal “upward” slope, there’s an “inverted” slope, or in other words, where the curve appears to “turn over”, starting from the left hand side and heading downwards to the right.
An inverted yield curve is unusual; it reflects bond investors’ expectations for a decline in longer-term interest rates. This signals investors’ belief that weaker economic conditions are ahead and that short-term rates will become increasingly attractive relative to long-term rates. Therefore, an inverted yield curve is viewed as a possible harbinger of a general economic recession. Market participants and economists use a variety of yield spreads as a proxy for the yield curve. This may include the 5-2 yield spread, the 10-2 yield spread (also known as the steepness), the 30-10 yield spread, the 10-3 yield spread, and the 20-3 yield spread.
Recessions are bear markets made uglier and generally less pleasant, and thus, anyone seeking to protect their portfolio has good reason to want to monitor inverted yield curves for clues that a downturn may be coming. Economists often use the terms ‘inverted yield curves’, ‘negative yield curves’, and ‘flattening yield curves’ interchangeably. It’s important to remember, however, that an inverted yield curve doesn’t necessarily lead to a recession, but it is certainly an important factor to consider when assessing economic conditions.